How the market responds to the November inflation number will be the big wild card. Throughout 2022, a higher inflation rate has led to higher Treasury yields, but we’ve started to see cracks in that relationship, notes David Dierking, editor of The Street's ETF Focus.

In the first half, higher inflation readings have come with an unknown terminal Fed Funds rate, so it was easy for Treasury yields to adjust higher.

Recently, the market has gotten at least some consistency and consensus in the idea that the FFR will top out at 4.75% to 5%. Whether that ends up being the ultimate top remains to be seen, but the level of market uncertainty around it right now is certainly lower than it was.

Let’s take a look at what might be considered the two most likely outcomes of this week’s upcoming inflation report.

Outcome #1: Inflation Comes In Lower Than Expected, Stocks Rise, Treasuries Rise

In 2022, stocks and bonds have mostly moved together. In this scenario, equity investors cheer the idea that the inflation cycle continues to moderate and bond yields follow along with the theme that falling inflation will lead to the Fed taking less action. This might be the outcome that the market is expecting the most right now.

Outcome #2: Inflation Comes In Higher Than Expected, Stocks Fall, Treasuries Fall

This is what has happened most often this year and the logic is pretty much the reverse of what I laid out above. If this happens, we’re probably looking at the stock market gains of the past two months proving to be just another bear market rally and an indication that the bond market, once again, doesn’t really have the sense that they know when and where rate hikes will stop that it thinks it does.

Either of these scenarios has stocks and bonds moving together again. What happens if the two asset classes disconnect? This is where the real risk lies.

Outcome #3: Inflation Comes In Higher Than Expected, Stocks Fall, Treasuries Rise

This is, I fear, what could happen and it’s probably the big “flashing red warning lights” outcome. The move in bonds is the key here. If Treasury yields fall in spite of higher than expected inflation, it’s an indication that investors are panicking and running to Treasuries for safety despite the inflation backdrop that has resulted in higher rates all year.

This is the outcome that could trigger a potential sharp and severe decline in equities through the end of 2022 and into 2023 because it doesn’t seem to be on the market’s radar right now.

Outcome #4: Inflation Comes In Lower Than Expected, Stocks Rise, Treasuries Fall

This feels like a really low probability. The equity market rise would be understandable if inflation falls again, but the Treasury market move would be curious.

I suppose this could be interpreted as bond market capital, especially the money that’s flowed into Treasuries over the past two months, would turn risk-on and move back into stocks. Whether it’s fully justified or not, this would be investors going all-in on the falling inflation narrative.

My Prediction

I’m in the minority here, but I think that Outcome #3 is most likely of the four outcomes. I’m definitely not saying that this WILL happen, but I think the recent data we’ve seen over the past month and the sequence of returns suggest that this is a real possibility. And I think that the bond market is sniffing this out.

Regardless, investors might want to consider positioning themselves cautiously here. There are some pretty big wild cards at play here and I don’t think the outcome is nearly as certain as the market thinks it is.

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