EconPundit

Looking at recent developments in Taiwan, China, and Hong Kong, it seems to me that the potential for an explosive crisis definitely exists and that this has gone remarkably unappreciated in the broad financial market community. In some ways, the circumstances today seem almost scripted to lead to a blow-up in relations across the Taiwan Strait, and the exposures in the financial markets to such a shock are immense.

Why are the dangers of a sharp and possibly deadly escalation of the China-Taiwan conflict so great in my view? Consider the following:

1. Taiwanese politics are in an unusual state of disarray. The Taiwan presidential election on March 20 produced a disputed outcome, with the incumbent President Chen winning 50.1% versus the challenger Lian with 49.9%. Fewer than 30,000 votes separated the two candidates, and a recount was demanded and will now occur. Meanwhile, half a million people were in the streets last weekend protesting the vote results, with the losing candidate on hand to fuel things.

2. The Chinese government is deeply unhappy with the incumbent president's positions on independence. Chen has supported the adoption of a Taiwanese constitution that Beijing believes would amount to a declaration of independence. Moreover, he explicitly rejects the "One China" policy, whereas the Chinese leaders insist that they will not open talks with his government unless and until he openly accepts that principle, which has also been the core of US policy for decades.

3. There was a failed assassination attempt against Chen and his VP the day before the election, giving birth to numerous conspiracy theories that have poisoned the climate. Some have accused the Chinese government of being behind the attempt on Chen's life, while some say that Chen might have staged the event to gain sympathy votes and have these put him over the top in what was an extremely close election. Additionally, Chen told the Washington Post in an interview that his survival of the attack and subsequent election victory have led him to conclude he has been spared so as to push forward with his agenda for Taiwan, regardless of what anyone (presumably including US officials) might say.

4. China has driven something of a wedge between the US and Chen on the issue of steps toward independence. When the Chinese president was in the US last year, President Bush said at a news conference that his government is opposed to such steps at this time, and sees them as inconsistent with the "One China" strategy for resolving the dispute.

5. The US is mlitarily distracted to a great degree by the problems in Iraq and Afghanistan. Chinese officials might judge that the superpower is much more limited now in its ability to respond militarily to trouble in East Asia than it is apt to be in future periods, as its resources are committed elsewhere.

6. The Beijing Olympics are still four years away, plenty of time to smooth things out if a crisis erupts now. By contrast, if China waits until Chen moves forward with his plan to hold a referendum on the constitution by 2006, by then time will be short before the Olympics, and the government mightl feel more constrained about taking military action for fear of generating a boycott of that hugely important spectacle. No doubt some officials in Beijing feel the Soviet Union would have been wiser to move against Afghanistan in 1977 rather than December 1979, whe the Moscow Olympics were set for 1980 (and were ruined by a Western boycott).

7. China is already tightening the screws in its political controls over Hong Kong, and Chen and other supporters of Taiwan's total independence from the mainland are pointing to this as support for their positions.

8. The Chinese economic leadership has signaled it wants and will work to generate a significant slowdown in economic growth over the next year or two. This no doubt will generate some social strains, which might generate some agitation against the rulers. It would be convenient for those leaders if an external crisis in the near term solidified national support for their regime while this was occurring on the domestic economic front.

Should a political and/or military crisis erupt between China and Taiwan now, it could generate a swelling of anti-China sentiment in the US especially and the West in general. That might cause significant damage to the Asian economic growth outlook by throwing up roadblocks to trade between China and the G7 in particular. Also, if the mid-1989 experience following the Tianenmen Square mess is any example, it might cause a sharp spike up in demand for dollars coming out of various places in Asia. This could be a potent combination of pressures for large leveraged speculators, who appear to be betting heavily on trades that should suffer mightily under those circumstances (long yen, long Japanese and Chinese stocks, long various economically sensitive commodities, short dollars).

Tax refunds have lost momentum earlier than expected, and this may already be undermining sales at large chain stores. Year-to-year refund growth was only 3.7% last week, and 6.9% over the past two weeks combined, whereas previously it had been running above 10% for the season (since the beginning of 2004). The fact that refund growth has slowed to this degree this early suggests there will be a much smaller increment to disposable incomes from this source than had been anticipated.

It looks as though discretionary spending is already losing strength as the refund stimulus fades, and also in response to higher gasoline prices. Year/year growth in sales at large chain stores was 6.6% last week, still high in an absolute sense but down from the 7%-8% gains of immediate prior weeks, and the lowest since February 7 when refunds fist started to kick in.

An acceleration in job growth clearly will be needed to keep spending aloft in the weeks and months to come. Friday's employment report may provide some evidence this is occurring, judging from the further dip in layoffs in the weekly initial unemployment claims figures. However, this month's payroll jobs count will be artificially inflated by the end of the California grocery workers' strike, which should boost recorded payrolls 50,000-60,000 in March.

The guts of the February durable-goods orders and shipments figures are rather soft, especially given the forward momentum suggested by the levels in various manufacturing activity surveys such as the ISM report. Although total durable-goods orders rose 2.5% on the month, all of this gain and more came from the three volatile groups: defense (+11.8%), civilian aircraft (+96.9%), and motor vehicles and parts (+5.0%). None of these gains was particularly surprising, in that all three sectors were coming out of unusually low readings in the prior month.

Demand for capital equipment appears to have suddenly flattened out. Nondefense capital goods orders excluding aircraft in February were below the previously reported January level, as the 1.1% monthly reported rise was more than offset by a downward revision of 1.6%. Meanwhile, shipments of nondefense capital items were down 0.6% and revised down an additional 1%. This coincident indicator of capital equipment spending has slowed to a 6.9% annual growth pace this quarter from 12-1/2% annualized in the second half of 2003.

Bookings for durable consumer goods and materials are not particularly impressive these days either. Excluding motor vehicles and parts, orders for noncapital goods slipped 0.1% in February and were revised down an additional 0.6%. This key subsector of new orders has essentially moved sideways on an average basis since the September/October time frame, a very surprising result in light of the robust ISM and regional survey new orders results. This raises a question of whether an even greater proportion of inventory restocking than realized has been diverted to foreign suppliers, especially as regards consumer goods and Asian manufacturers.

Chairman Greenspan is known to pay very close attention to this report -- he saved it from the scrap heap when budget cuts threatened its existence a number of years back, and he has made reference to a number of its components repeatedly over the years. Certainly this sort of news should reinforce his pre-existing preference for maintaining the extremely low federal funds rate environment.

This morning, all the chatter on the radio about the stock market was to the effect that things had gotten way overdone to the downside, according to "experts." No doubt this view was reflected in the overnight and market-opening action, when the S&P 500 futures and index were trading up 4-6 points after falling more than 14 points yesterday. These gains didn't last long, though, and by the close it was another down day for the key indexes: S&P down 1-1/2 points further, and NASDAQ down 0.4%.

The fact that the market "has fallen and can't get up" is very telling, because sentiment remains very bullish and the rationale for this bullishness hasn't changed since the beginning of the year. Supposedly, the market will rally this year because of (1) unusually accommodative Fed policy, (2) improving economic growth, and (3) positive corporate earnings momentum. Never mind the fact that all 3 of these conditions have existed for some time, and have had plenty of time to be fully discounted in market prices.

The view here has been and remains that the stock market is extremely vulnerable from a technical perspective, reflecting lopsided bullish sentiment and positions and enormous degrees of financial fragility across a range of sectors. When the handle on the Dow falls below 10000, probably very soon (only 63 points away now), that will grab headlines and catch the attention from the broad public that this market selloff thus far has lacked. Ultimately, as asserted in earlier comments on this site, much lower levels are probably in store, both in 2004 and (especially) beyond. Those who retain the bullish opinion should be asking themselves right now, why hasn't the market bounced more this week?

Weekly figures show that tax refunds rose 9.9% year/year last week, down from 15-16% in the prior several weeks. For the refund season to date, the volume of these checks issued has risen a little over 10%.

Thus it appears that sequentially we may have passed the peak of strength in tax refunds as a force expanding household spendable incomes. This is important because, in the meantime, the stock market has hit the rocks and to us is still showing every technical sign that it will move much lower before long. A combination of substantially slower disposable income gains and a severe hit to equity-market wealth could generate downward pressures on consumer outlay growth by midyear. Perhaps there is already a sense of dread creeping in about this risk; indexes of retailing stocks look very poor on the charts these days.

Not only was the 0.7% rise in industrial production last month far stronger than estimated, but the breadth of the advance across different key sectors was impressive. Manufacturing climbed 1.0%, with a 0.9% rise excluding motor vehicles and a 1.6% gain in the vehicle and parts groups combined. Production of nonenergy materials moved up 1.0%, and business equipment output rose briskly across the board, with a 2.1% in high-technology and a 1.1% jump in other areas. Meanwhile, consumer nondurable good production increased 0.6% for the second straight month, marking an acceleration in growth this quarter.

These data bring the Fed's industrial statistics into better alignment with the robust reports out of the ISM since last fall.

This morning the euro has rallied moderately against the dollar, in the wake of important developments in Spain over the weekend. First, evidence mounted that al Qaeda was indeed behind the bombings in Madrid on Mar. 11. Second, in national elections on Sunday the governing party was beaten soundly by the Socialists, who had as one of their platform planks a promise to bring home the troops from Iraq by midyear.

The view here is that these developments are fundamentally quite negative for the euro, in both economic and political terms. Economically, the bombings and the al Qaeda responsibility are apt to strike a blow against domestic demands in the region, and also should weaken tourism and investment as external parties rethink the dangers of visitation and financial commitments. Regarding politics, the swing in voter sentiment toward the opposition in Spain raises red flags about the possibility of a widening rift between the US and Europe in the war on Islamist terror. Such a rift -- in effect, growing isolationism that looks a lot like appeasement in Europe -- would remind people of what happened to the region the last time the US and Europe went different ways politically, in the 1930s and 1940s. Not many investments in Western Europe undertaken in that period turned out well.

Pressures on the ECB for renewed easing are apt to grow, and that too should weaken the euro as the central bank most likely will do as usual and wait until the economy demonstrates it is in very bad shape before acting, too little and too late. The declines in regional stock markets over recent days suggest that equity investors already appreciate there has been an increase in the risk premium required on European assets, and this is not consistent with continued firm trading in the regional currency.

Virtually all of the markets have moved sharply against the reflation thesis in recent days, but in our view much more of an adjustment lies ahead, and this will cause severe losses for those who retain positions rooted in this concept. Stock prices have plunged, the dollar has rebounded, and bond yields have declined sharply since one or two weeks ago. The only market that is holding out is that for commodities, but it too likely will crumble soon. In particular, gold (now $400/oz) and silver (currently around $7.10/oz) see very vulnerable because the notion of accumulating precious metals to hedge against inflation has been very popular with leveraged accounts recently. Don't be surprised if both come down very rapidly in the near term.

As first orders of business, we would expect soon to see: (1) The S&P 500 test the 1000 level or a bit lower, meaning we'll get another 10% decline in the stock market from here, (2) bond yields head down again to roughly 3.5%, on their way to 3.25% and below, and (3) the dollar index crash through resistance at 89.25-89.50 and head toward 91-92. That would imply dollar/euro at around 1.17-1.19, and yen/dollar back into the 115-120 zone that dominated trading prior to late last September.

Ultimately, much more dramatic changes may lie ahead for the financial industry. If the S&P breaks 950-975 then the technical measurement would be all the way down to 600 or less. What sort of world would be required to make that a reality? In essence, the financial sector's share of total GDP would have to decline steeply back toward the levels seen in 1950s-1970s, rather than in the extreme high zone of recent years. It goes without saying this would mark a seminal shift in our national focus.

Retail spending has a big head of steam in early 2004, notwithstanding the flat month/month reading on nonauto sales for February. The latest report showed large upward revisions to core nonauto sales for December and January, so the flat February figure is very misleading. The updated trend on core spending growth at retail outlets this quarter (excluding autos and building materials) is 9.6% annualized, versus 9.1% previously. You get the same 0.5% upward revision if you further exclude gasoline, which I would do because it is so heavily influenced by price rather than volume changes (now 8.6% compared to 8.1% before the new data).

It's hardly surprising that Q1 is proving to be a strong period for discretionary consumer spending, when you consider the sharp inflation of disposable incomes taking place right now as a function of tax refunds, which are a predictable, belated effect of the mid-2003 tax rate reductions. The danger, however, lies over the horizon in the second and third quarters, when those rebates are history and there are no fresh tax cuts coming. At that point, disposable income growth will fall sharply unless employment increases have accelerated appreciably in the interim.

Although the headlines today scream, "Another record monthly deficit!," the news beneath the surface on US trade patterns is not so bad after all. True, the gap climbed to $43.1 billion from $42.7 billion in December (revised slightly wider). However, all of this increase and more came from a $800 million jump in the cost of petroleum imports, the great bulk of which was driven by higher prices rather than stronger volumes. In inflation-adjusted terms, the merchandise trade deficit actually narrowed by nearly $700 million, to $49.8 billion in 2000 dollars. That's only marginally wider than the $49.1-billion gap in Q4 on the same basis, and that degree of deterioration is minor in light of how much faster the US economy is growing versus the average growth rates of our trading partners.

When volatile categories such as oil imports and aircraft exports are excluded, the longer-term trends don't look too bad at present. Year-to-year, goods imports excluding petroleum are rising at about 7%, whereas goods exports excluding aircraft are up close to 9%. That doesn't mean the trade deficit will be narrowing soon, because (a) imports are about 1-2/3 the gross size of exports, and (b) as noted above, it's normal for a trade gap to expand when a country such as the US is growing much faster than its trading partners. Still, properly interpreted these are not bearish numbers for the dollar in foreign exchange markets.

The financial and asset markets since last Friday have moved toward greater harmony, and are all now tipping toward disinflationary/deflationary patterns. The huge rally in the bond market was furthered on Monday, by 7-8 basis points, bringing the 10-year Treasury yield down to 3.75%. We continue to believe it will move down more in the weeks ahead, probably to 3.25% and below by late spring or summer. Whereas commodity markets and equity markets at first rallied on the weak jobs data and surging bond market, they have since turned weak. This represents a break in the prior relationships, and thus suggests that the reflationary psychology that has gripped all the markets since last spring -- driven by expectations that the Fed move levers to soak up excess capacity -- is breaking down. Tax refunds are surging, and this is spurring strong growth in retail sales, but we are at the peak of fiscal stimulus right now for what likely will be many years, whoever wins the presidential election. Markets may start discounting the fact that the sequential impulse of fiscal policy will turn restrictive after May this year.

The equity market is increasingly vulnerable to a stiff setback, possibly a collapse. Once market participants lose faith that the reflation hypothesis is correct, they will tend to focus more on the negative income fundamentals for the corporate sector that derive from disinflation/deflation pressures. Although bond yields have fallen, and that lowers the interest rate assumptions for dividend-discount models, the risk premium on equity assets should rise sharply if deflation looks like more of a risk, as it should. Technically, the NASDAQ has broken back down below its 50-day average and should head swiftly toward the 200-day average which is about 5%-6% down from Monday's close. The S&P 500 sits precariously above its Feb 4 low close (1126.52), and the Dow Insudtrials are flirting even more dangerously with their low close that day, with only a 30-point cushion at this writing. Equity bullishness is so rampant (95% among individuals in the Yale Univ. survey; 92% among institutions; more than a 40% gap between bears and bulls in the Investors Business Daily survey) that a breakdown here could lead to a rush for the exits and a collapse.

Meanwhile, some analysts are arguing that the Fed should raise interest rates to pop asset bubbles. Morgan Stanley's chief economist Stephen Roach is out with pieces arguing that the Fed should raise rates by 200 basis points by summer, to 3%. If this kind of chatter gains any traction at all, it could lend dramatic downward pressure to equity and commodity markets.

The view here is that we are poised for potentially sharp and unexpected hits to wealth and confidence, that will have knock-on effects in all the markets and the world's economies. The recent trends -- falling bond yields, rising dollar -- should be joined by falling stock and commodity prices very shortly. Disinflation reality will probably soon turn to renewed, perhaps intense, fears of deflation. There will be huge losses in the financial community as a result of failed and leveraged reflation bets that are being shaken out.

In the end, the Fed's next move more likely will be to ease rather than to tighten, in an effort to try to cope with the damages outlined above. It is not impossible that this move could take place before the end of calendar 2004.

The responses of markets to the weak February employment data appear to be internally inconsistent, and are likely to be resolved over time in one direction or another. The view here is that the resolution will be in directions consistent with extremely low and still falling inflation, which implies poor income (including profits) growth and no momentum for reflationary attitudes for now. These should mean lower bond yields, as we see today, but also lower stock valuations, lower commodity prices, and a firmer dollar exchange rate.

Job growth remains remarkably poor overall, though employment levels have finally stabilized in manufacturing, as had been suggested by the ISM surveys (Feb. ISM employment component at a 16-year high). What is lagging far behind historical norms is service-sector hiring. The 3-month nonmanufacturing payroll diffusion figure last month (52.8%) is no better than it was in the September/October 2003 time frame, even though the economy has sprinted forward judging from GDP and numerous other reports. Meanwhile, average hourly earnings growth has slowed to just 1.6% year/year, down from 3% or more as recently as end-2003/early-2003. Bond yields plummeted on the news -- the 10-year US Treasury yield is down 18-20 basis points -- while stock prices are little changed and commodity prices have surged. Regarding stocks and commodities, the judgment seems to be that this report will lock down the Fed at 1% rates for a further period, and that is seen as positive for stock pricing as well as inflationary for commodity demands.

The main message of this report to my eye should be that disinflation persists, and that it is squeezing corporate profitability and making managers very reluctant to hire. The unifying theme should be that the economy is running strong on very little internally generated fuel, which should be read to mean increased risk premiums on equity assets are warranted. Also, the meaning should be that commodity prices surges such as we have recently experienced in things like petroleum, copper and lumber will likely prove self-limiting because they will damage profits and thus further depress corporate demands for goods and labor.

Bond yields deserve to fall, for all the reasons discussed in earlier posts. The market had built in an enormous cushion against future Fed tightening, which now looks to be further down the road. But it is a mistake for other markets to judge the bond yield decline as bullish for stock and commodity prices. Market participants should be thinking that the root cause of the pressure for lower bond yields is falling inflation, and disinflation from today's extremely low levels is a very dangerous thing because it hikes the burden of the existing private debt and makes corporate profit leverage harder to achieve.

Going forward, look for the bond rally to continue over time, perhaps to 3.5% or below before mid-April. What should change soon is the perception that lower bond yields are the savior for long-stock and long-commodity positions.

After looking even more closely at the adaptive-expectations bond yield model, the probability of a 75 basis point or greater rally in the bond market (10-year Treasury yields down to 3.25% or lower) looks ever higher. Such a rally would be a delicious rebuff to the expectations of the financial community today, since there is almost no analyst anywhere willing to forecast a 10-year yield below 4%, let alone anything as low as 3.5% or 3.25%.

Based on the trailing 36-month average of 3-month Treasury bill yields (1.77%), and a normal risk premium for 10-year notes on a constant-maturity basis (around 125-130 basis points), the model says the 10-year Treasury yield in equipoise today should be around 3.05%. Instead, the yield on the current issue is around 4.05%, and a constant-maturity yield (counting all issues, adjusted to exactly a 10-year maturity) would be a bit higher. This 100 basis point yield premium in the market today represents 1 standard deviation above the mean for the gap between the actual and model yields. As noted below, there were 24 previous months in the past 20 years when actual yields were one standard deviation or more above the model estimate.

Looking at it more closely, I've determined that this is the first time at least since 1970 when such a large gap existed between the actual and the model yield before the Fed had begun a rate tightening cycle. Once the Fed begins a tightening round, it is natural for bond yields to overshoot to the upside because of uncertainty about how much of a tightening will be required, and the unwinding of leveraged positions undertaken during the easy-money period. However, the norm before a tightening has begun is for the actual bond yield to be at or below what the model would suggest. In today's terms, that means that normally the actual yield today should be 2.75%-3.0%. Thus, by historical standards the market today already has priced in a huge buffer for the possibility of an early, sharp tightening by the Fed. This conclusion is sharply at odds with the view in markets that 4.0-4.25% bond yields are impossibly low. That judgment I believe is merely a "sticker shock" phenomenon, since we haven't seen bond yields lower than this level for more than a few months in the past 40 years.

Despite the significant ramp-up in manufacturing production over the past several months, data show that inventories have continued to get leaner relative to sales. The January factory data released this morning show a 0.2% rise in total stockpiles, which lagged the 0.5% rise in shipments/sales for the month. Thus, the overall manufacturing I/S ratio fell again to 1.255, down 4% over the past six months (not annualized).

More striking still has been the lack of any pickup in finished goods inventories over recent months, while sales have been booming (factory shipments up at a 12.6% annual rate in the latest three months). Finished-goods inventories in January were down 0.4% month/month, so the I/S ratio for finished goods has fallen even faster than that for total items on hand.

It is clear that manufacturers still have a long way to go toward beefing up their activities to address the sizable increase in demands for goods. This is also evident in the steady and appreciable slowdown in delivery speeds reflected in the ISM's vendor performance index. The upshot should be a major pickup in factory hiring over the months to come. We may see evidence that this is beginning in the February labor report due on Friday, March 5.

We have taken the position that bond yields are more apt to fall, and perhaps by a great deal (50-100 basis points) in the weeks and months ahead (from current levels around 4.00-4.10% on the 10-year US Treasury note). This view is starkly different from that of the general analystical and forecasting community. For example, a recent poll by Merrill Lynch found that 59 out of 59 analysts surveyed thought that 10-year yields would be higher in six months. It is extremely rare for opinion to be so unified about the prospects for any financial asset, and it represents a flashing red light that current market bond prices and yields already reflect an extreme degree of negativity on the asset class. Clearly, the "pain trade" here is for lower yields just as it is for a higher dollar (see below).

Here are two other reasons to think yields may drop to a stunning degree:

1. An adaptive expectations model suggests the current equilibrium 10-year yield is around 3.25%. Historically, the 10-year Treasury has been closely correlated with a 36-month trailing average of the 3-month bill rate. This reflects the tendency of investors when choosing between different assets to assume that the future will look a lot like the recent past. Thus, what represents a "low" or "high" yield on a long-term note typically is judged by what yield spread it offers relative to recent money-market norms. Currently the 36-month trailing mean of the 3-month bill is 1.80%, down from 3.38% a year ago. The average spread of the 10-year to the bill rate in the past 15 years has been around 1.4%. Thus, at around 4.05% the 10-year Treasury is one full standard deviation above what the adaptive expectations model would normally direct. Since 1984, an upward deviation of this or greater amount has occurred only about 10% of the time. In those prior episodes, bond yields fell by an average of 40 basis points over the following three months.

2. Yields on inflation-protected Treasuries have plunged this year, perhaps a leading indicator decline in nominal yields. The 10-year TIPS yield now stands at around 1.55%, down from 2% at the start of the year. This is roughly double the magnitude of decline in nominal 10-year yields over the same period, and it has brought the spread out to 2.5%, the widest in the 7-year history of the TIPS market. Normally the spread is highly market directionall, widening in a bond-market selloff and narrowing in a rally. That's in large measure because TIPS is a small, highly illiquid market that tends to move more glacially. It is uncharacteristic for the spread to widen in this fashion during a period when the bond market as a whole has been strengthening, and especially in the midst of declining core inflation measures. Any turn in sentiment toward lower inflation risk -- even a mild change, let alone a stiff deflation shock such as would be generated by a plunge in the stock market or commodity prices -- could drive down the nominal yield sharply and bring it into more appropriate alignment with the TIPS.

Today the US dollar index broke out to the upside, clearing the 88.00 level (March 2004 contract basis) that had provided so much resistance over the past few months. Predictably, the dollar then followed through in a surge against both the yen (to 110.40) and euro (to 1.219).

Much more dollar strength probably lies directly ahead. It now looks much clearer that we have been forming a durable bottom formation on the charts since late 2003. From most appearances, leveraged speculators have been placing their money overwhelmingly on the side that the yen was heading to 100 and then 95, and the euro to 1.30 and beyond. Therefore, the market action that will cause the greatest pain by far is a further dollar rally. Rudimentary charting techniques suggest the dollar index will move fairly swiftly into the 90.30-91.00 zone, perhaps by the end of this week. That would be consistent with a yen/dollar rate heading toward 111.50-113.00, and the dollar/euro to something like 1.1850-1.200.

Hedge fund losses in the currency market could be very large. This may force them to unwind other popular positions: long credit products (mortgages/corporate and junk bonds), long small-cap stocks (especially technology), long commodities (especially gold).

Today's reports present two very different pictures of the current inflation situation:

1. The ISM manufacturing survey from February (composite index down to 61.4% but still strong) points to a sharp ramp-up in pricing pressures and related strains. The ISM factory price index surged six points to 81.5%, a nine-year high, and the vendor performance (measuring slowness of supplier deliveries ) also increased, to 62.1%. Together, these figures indicate producers are experiencing strong hikes in their input costs at the same time that they are having difficulty keeping up with order flow. These conditions normally are a recipe for price boosts at the wholesale level.

2. The personal consumption price deflator for items other than food and energy remains very weak, rising 0.1% for January and only 0.8% annualized in the latest six months, matching its historic low.

So is inflation quiescent or beginning to jump? Our inclination is to believe the former. Intense global competition in tradeable goods makes it extremely difficult for US firms now to hike prices and thereby pass through their cost increases. Thus, most likely what we are witnessing here in the apparent divergence of these price indicators is a squeeze on profitability for domestic goods-making firms. This is another reason to be anxious about the lofty valuations in the equity market.