Markets Rallying on Bad Data: Stagflation Here We Come?

Despite poor economic numbers, the Dow Jones, the NASDAQ, and the S&P 500 all rallied on Thursday morning. Is this a sign of increasing inflation expectations among investors? On Thursday, the Labor Department reported jobless claims of 414,000. The number represents a drop of 16,000, but any number over 400,000 is seen by many economists as evidence of a poor economy, CNBC reports. At the same time, the Philadelphia Federal Reserve Bank reported a drop in its business activity index. The index fell to negative 7.7 (-7.7) from positive 3.3 in May. Perhaps most shocking is that the general consensus among economists was a rise in the figure to 6.8, according to Reuters. Traditionally, investors might anticipate a drop in the markets given the data. Yet, the markets are rallying. Why? The U.S. dollar index was up on Thursday as well. However, that may be due to the ongoing crisis in the Euro zone. The euro may be becoming so unattractive to forex traders that they are swapping them for dollars despite the problems in the States. Are problems in the euro driving U.S. equity markets? Given the current state of the world's economy, anything is possible. However, something much more sinister may be occurring. Perhaps investors are now pricing in a third round of quantitative easing, hoping to front-run the Federal Reserve. After the Fed rolled out its previous two rounds of QE, U.S. markets rallied sharply. Are investors buying on hopes of QE3? Despite the Fed's anti-QE rhetoric, and the fact that a recent survey indicated that most professional forex traders do not expect to see QE3, retail investors and fund managers might be anticipating it. If that is the case, then it indicates that investors and money managers are pricing in higher stock valuations—effectively raising their inflation expectations. Given that, if the Fed does undertake QE3, the U.S. could quickly have an inflationary problem on its hands. Assuming the Fed realizes this, they may wait for markets to begin tanking before taking action, an idea noted economic forecaster David Tepper outlined last week. Of course, Thursday's action might have nothing to do with the anticipation of QE3. Maybe investors are shrugging the data off and anticipating a recovery later this year. Given the current state of the world, it seems as if anything could be possible.