Volatility has been low the past two weeks. This can be seen in the weekly chart of SPDR S&P 500 ETF (NYSE: SPY) below.

The next chart puts this volatility in context. The blue bars highlight periods of low volatility, times when the weekly range of the S&P 500 is less than 1%. Since 1993, we have enjoyed many periods of low volatility.

High volatility has been associated with bear markets. Three of those periods are shown in the chart. There was also a high-volatility bull market in the late 1990s when the internet bubble pushed prices to irrational extremes.

The next chart looks at money supply. These blue lines indicate times when the money supply is growing rapidly, like it is now.

The Federal Reserve seems to increase the money supply to offset the bear market declines. Bear markets are also times when the economy is contracting. Now, let’s think about what this says about current conditions…

What This Means…

Volatility is low, and that is often associated with a rising stock market. But money supply is increasing rapidly, something we tend to see when stock markets are falling.

The current situation tells me we need to seriously begin worrying about inflation. (I touched on this briefly last week.) For now, a significant amount of that money the Fed created is moving into the stock market. But the economy is recovering more rapidly than many investors seem to realize.

The next chart shows that the New York Fed Staff Nowcast, a real-time forecast of GDP for the current quarter, is at 8.3%. Nowcast jumped 1.6% last week after we saw positive surprises from advanced retail sales, building permits, industrial production, and capacity utilization.

Source: NY Federal Reserve

The economy seems to be overheating as Congress prepares a $1.9 trillion stimulus spending package. This could be the spark that creates higher inflation — and that could lead to a bear market in stocks.

The last chart for this week shows why inflation is a threat to the stock market. This is a chart of 10-year Treasury note futures. The bull market in Treasuries has been intact since the market was created in the early 1980s.

Notes are the technical term for obligations maturing two to 10 years after they’re issued. Bonds mature more than 10 years after issuance. Bills mature in less than two years.

Prices and interest rates are inversely correlated. When rates rise, prices fall. If rates rise 1%, the price of a 10-year Treasury is expected to fall about 8%. This will represent a significant loss of capital for fixed-income investors. Many of these investors use leverage to boost returns. Leverage will increase losses even more. That could lead to selling in the stock market to raise funds for margin calls.

Action To Take

The bottom line is that the stock market is likely to fall if inflation picks up… and inflation is likely to pick up. The only question is when.

I’m closely monitoring the situation, gathering more data and keeping close tabs. I’ll be sure to share what I learn as soon as possible.

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