The stock market just had its best month is almost two years. Now we all know that the stock market hasn't reflected the real economy for many years, but what's going on now is nothing short of "bad news is good news".

“You’ve had 10-year Treasury yields come down precipitously,” said Rob Haworth, senior investment strategist at U.S. Bank Wealth Management. “With inflation so hot, I think the expectation is the Fed stays on path, but it’s damaging enough for the economy that they’re going to have to pivot in 2023.”

If that doesn't make any sense to you, you aren't alone.
The inflation rate that the Federal Reserve watches most closely hit a 40-year high, jumping 6.8% in June from a year ago. Earlier this month, the consumer price index rose 9.1% from a year ago, the biggest gain since November 1981. Now compare that to what the bond market is doing.

The bond market expects inflation to absolutely collapse in just the next few quarters. That would lower borrowing costs, which is caused the stock market to rally.
But how likely is that?

Inflation surged in June and workers’ average wages accelerated in the spring — signs that Americans won’t likely feel any relief from rising prices anytime soon and that the Federal Reserve will feel compelled to further raise borrowing costs...more persistent drivers of inflation show little, if any, evidence of slowing.

So why did the markets rally when inflation was increasing and the economy was shrinking? Because Fed Chief Powell said: ‘‘We are now at levels broadly in line with our estimates of neutral interest rates, and after front-loading our hiking cycle until now we will be much more data-dependent going forward.’’
What this means is any further increases are going to put the Fed in a more restrictive territory.
As for the "data" the Fed will be referring to, it includes bond market expectations (aka navel-gazing).

Using CPI inflation swaps, I calculated the one-year forward, one-year inflation break-evens — basically, the expected inflation between July 2023 and July 2024, which is represented in the chart above and sits at 2.9%.

Remember that the Fed targets (core) PCE, which tends to historically be 30-40 bps below (core) CPI: Essentially, the bond market expects inflation to slow very aggressively and roughly hit the Fed’s target in the second half of 2023 already!

Let's recall that the Fed has been consistently behind the inflation curve for more than a year now. Way back in early 2021, the Fed said that inflation was going to be temporary, and only for a few months. The financial markets bought into that.

However, not everyone is on the same side of this bet on future inflation.

The demand for Series I bonds, an inflation-protected and nearly risk-free asset, has skyrocketed as investors seek refuge from soaring prices and stock market volatility.
While annual inflation rose by 8.6% in May — the highest rate in more than four decades, according to the U.S. Department of Labor — I bonds are currently paying a 9.62% annual rate through October.

So the yields on inflation-adjusted Treasury bonds is going up (disclaimer: I bought these for myself), while the yields on non-inflation-adjusted Treasury bonds is dropping to less than a third of those yields.

With most Treasury yields back below 3% and the Federal Reserve expected to raise rates to at least that level by the end of the year to throttle inflation, bond investors need ongoing confirmation that Fed rate hikes are biting the economy.

Someone on Wall Street is very wrong on this bet.

So what does this mean, if the Fed and the markets are wrong about inflation yet again?
Consider these three surveys.

#1. The small business network Alignable released new survey results that found that 35% of U.S. small business owners “could not pay their rent in full or on time in June.”

#2. About 45 percent of small-business owners in the United States are freezing the hiring of new workers because of high labor costs and skyrocketing inflation, according to the Alignable July Hiring Report.

#3. As The Center Square previously reported, a survey found 51% of small businesses fear that rising prices could “force them to close their businesses within the next six months.” In particular, restaurant owners are concerned, with 72% saying they are worried.
That concern is not new. An April poll from NEXT Insurance reported that many small businesses have considered shutting down because of inflation.