James Bianco, president of Bianco Research, thinks that a return of inflation will force central banks to accelerate their exit strategy and warns that financial markets won't like it.

Wall Street is rattled. This week, the long-running stock rally turned into a rout. On Monday, the Dow Jones suffered its largest one-day decline since the summer of 2011. After stocks came out roaring at the beginning of the year, investors now are facing a lackluster performance for 2018. For Jim Bianco, the sudden plunge is a sign that financial markets are finally showing concern about inflation. The influential market strategist from Chicago thinks that a return of inflation could force central banks to accelerate their exit strategy and that the basic relationship between stocks and bonds will change once again.

Mr. Bianco, financial markets have been thrown into turmoil. What is going on?

For the first time in the post crisis area the markets are finally showing concern about a return of inflation. This is something that we talked about and speculated about for a long time, but it never became an issue until now. The catalyst to this sell-off was last week’s employment report which showed that wages were up 2.9% in January, the fastest pace since June 2009.

Why are investors so concerned about that?

The reason the market is worried about inflation has to do with central bank activity. Central banks and especially the Federal Reserve have put out the idea that it could take up to ten years for them to unfold their unconventional measures. For instance, the Fed said that it might get its balance sheet back to normal in 2026. But built into this was the assumption that there would not be anything like inflation that would come along and force the Fed to move in a different pace. So now, if inflation materializes it forces central banks to move a lot faster.

Why is that a problem for financial markets?

I’m of the opinion that all central bank stimulus is fungible. Whether it’s the European Central Bank, the Bank of Japan or the Federal Reserve: it doesn’t matter who does it as long as stimulus is added. If you add up their balance sheets, they have accumulated an all-time high of 16.4 trillion dollars. So even though the Fed has raised rates five times and is expected to reduce its balance sheet, collectively the central banks are the easiest they have ever been right now. But if there is an inflation fear coming, it forces the hand of the two easiest central banks: the ECB and the BoJ. What will they do about it in response? Do they start to taper faster? Do they start to reverse? These are the questions that are the heart of what’s bothering the financial markets right now.

But isn’t a pickup in inflation also an indication that the economy is doing better?

Yes, we’re not talking about recession here. Inflation is a signal that the economy is doing better. That’s why a lot of people are of the opinion that a return of inflation is a good thing: It means that the economy is doing well and that the job market is robust. That’s what they have been wishing for and they’re wanting inflation to come back. They think that while there would be higher interest rates it would mean much stronger risk markets because there are going to be a lot of people selling their bond funds and buying stocks funds. Well, the reality is: be careful what you wish for.

Why?

To be honest, I don’t know whether or not a return of inflation is actually real at this point. But if it is, you’re not going to like the result of it. Now, that fear of inflation is here you’re seeing that people are starting to worry about the position of central banks, they’re starting to worry that there is too much debt in the market and that’s producing weaker financial markets and not stronger. So if you want inflation, be careful what you wish for because you won’t like the result of it.

Since the financial crisis, economists predicted time and again that inflation was just around the corner, but it never happened. What’s different this time?

The models that are saying inflation is returning in 2018 probably said the same thing in 2017, 2015, 2011 and many other times. Yet, it never materialized. Part of the explanation why inflation never materialized might be the Amazon effect: the internet is making things much more efficient and that has been holding down prices. But what’s different now, is that the market is taking it seriously. The market did not take it seriously in 2017, 2015 or 2011 when we thought inflation might return. It’s the market that pushed the yield on ten year treasuries up to 2.85% and that sent the Dow down 4,6% on Monday. But the most telling thing to me is the reversal of some of these correlations in the market.

What do you mean by that?

The correlation between stock market volatility and inflation expectations has been negative for a decade, meaning that when inflation expectations went up, volatility would go down and vice versa. But now, we’re on the verge of that correlation becoming positive for the first time since the financial crisis, meaning that as inflation expectations go up so does volatility.

Why is that so important?

This could be a return to the way that markets used to trade in the 1980s and 1990s. During that time, we traded with an inflation mindset: whenever we thought that inflation is coming back, up went interest rates and down went stocks. On the other hand, whenever we were relieved that there was no inflation, down went interest rates and up went stocks.

And how used markets to trade in the recent past?

Since 2000 we’ve traded with a deflation mindset: our biggest fear was deflation. When we thought that deflation was coming back, down went interest rates and – since deflation is bad for stocks – down went stocks. In contrast to that, when we were relieved that deflation was not a problem up went interest rates and up went stocks.

What does it mean when these correlations are changing once again?

People still think that’s the way we’re supposed trade right now. But if we’re transitioning to an inflation mindset like in the 1980s and 1990s, higher interest rates mean inflation which is bad for stocks – and add to that a set of central banks that are completely unprepared for a return of inflation because they’re in such an easy position right now.

Another remarkable development is the weakening of the US Dollar. How does the Dollar weakness fit into the whole picture?

I think it’s a confirmation of this reversal. I would argue that just like the correlation between volatility and inflation expectations has been turning up for the last year, the Dollar has been turning down. Behind both of those developments has been a concern about inflation. I think that’s been the primary driver. Look at it this way: Why would the Dollar be weakening with the strong economy? With the tax reform? And with everything else that has been going on with stronger interest rates? The Dollar shouldn’t be weakening unless you worry about inflation. That’s why the Dollar could be one of those warning signs we misjudged and tried to tie it to politics. But the Dollar maybe has been one of those things that are telling you inflation is coming.

So what’s next for the bond market? Is there a specific technical level which investors should watch out for?

On the ten year treasury note it was 2.63% from last year. We broke it last week and you saw the market sell off quite a bit. At this point, you now have to go with the 2014 high of 3.05% which is one of the highest levels in the post crisis era. If we take that out that would be a very big concern. We’re only around twenty-five basis points away from that level so we’re in a very weak technical position right now. Ultimately, if you’re a stock investor, what you would need to stop the route would be interest rates to stabilize and maybe even have a rally in bonds to signify that the market is saying: “maybe we overdid this inflation thing”.  Something like that happened on Monday after the Dow briefly went down nearly 1600 points during the trading session.

During this great bull market, it has always been rewarding for equity investors to buy such dips. Is this still a smart thing to do now?

The buy-the-dip-strategy worked because what never ever materialized during any of these dips was inflation. But if inflation returns, I think that jeopardizes the whole buy the dip mentality. So far, you had central banks that elevated markets and they have never been forced to really think about accelerating their exit because you never had inflation. So every dip has been a buy. But if central banks have to deal with inflation and have to accelerate their exit than a buying the dip mentality could really be a problem.

What’s your general take on the state of the stock market?

Stocks had a huge run. January has been the 15th straight month without a decline. Also, the Dow Jones went 404 consecutive trading days without experiencing a 5% correction. This week’s losses in stocks brought this streak to an end. The only time the Dow lasted longer without undergoing a 5% correction was the 437 trading days ending September 7, 1959. So if you understand that this has been the second longest run of this kind in the history of the Dow, you should understand that we might get into a period like we were in 2015 or in 2011 when we had several months of choppy to sideways markets with a lot of volatility. Gone is that period where the market never corrected and only went up.

So what should investors do now?

If we’re in an inflation environment in which both bonds and stocks struggle the whole risk parity trade is going to be problematic. It’s going to be very difficult to find a place that is going to perform well. This could be like the 1980s and 1990s: when markets went down, everything else went down as well, even investments like gold. So you really have to be careful in this environment.

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