Message of the Markets: Inflation Will Force the Fed's Hand, Crippling Recovery

Until the past 24 hours, the stock market appeared to be pricing in a V-shaped economic recovery, an outlook also supported by a very steep yield curve.

Jim Bianco, president of Bianco Research, says these indicators speak to the recovery of the financial sector far more than that broader economy, where the message is still "indeterminate."

The yield curve recently hit a record for steepness, meaning the difference between short- and long-term Treasury rates was as wide as it's ever been.

Typically, that's a very bullish sign for the economy, Bianco says, because a steep yield curve drives profitability for the banks and gives them a "powerful incentive to lend."

In addition, strong financial sector earnings give a boost to overall S&P 500 earnings, helping drive the rally: Heading into this week, S&P fourth-quarter earnings were projected to rise 62% vs. a year ago. Bianco notes financial companies were expected to grow operating earnings by 120% while non-financial companies were expected to decline 2%.

Against that backdrop, the recent market decline -- which was picking up speed midday Thursday -- makes sense given the disappointing results in the past week from Bank of America, Morgan Stanley, JP Morgan and Citigroup.

Wall Street vs. Main Street: In addition, Bianco notes the banks have been reluctant to lend in the aftermath of the credit crisis which made them much more defensive, both because of uncertainty about the regulatory environment and fears of more loan losses if the economic recovery stalls.

Should the yield curve stay steep for a long enough time, banks would feel sufficiently flush to start lending again, which would boost economic growth. That's the self-generating cycle bulls are counting on.

The big caveat to a steep yield curve is "it can also lead to inflation," Bianco says. "If that were to happen with the funds rate at zero you could get a lot of people in the credit markets very worried about inflation."

Noting inflation expectations based on the 10-year break-even point for TIPS is near a 5-year high while many commodities remain in earshot of their recent peaks, there are "a lot of worrisome signs inflation may be coming back," says Bianco, who predicts Treasury rates will rise this year.

The risk here is Bianco's forecast that inflation forces the Fed to begin its exit strategy sooner rather than later. Higher rates and a "flatter" yield curve will stop the recovery in bank lending before it really gets started, crippling the recovery in both the economy and corporate earnings.

If that occurs, the idea that only Wall Street (rather than Main Street) benefited from all the government programs will be confirmed -- and all populist hell will really break out.