Inflation Data Disappoints

A big week on Wall Street as the inflation data (CPI & PPI – more below) dispelled any notion that the Fed will be tapping the brakes on rate hikes at their next policy statement on Wednesday. Some of the Fed Funds Futures were incorporating some probability of a 100bps move this week but I think 75bps will be the number and there is likely to be stronger language on future rate moves.

The Reaction

Below is a chart of the S&P futures that show the reaction to the CPI report on Tuesday that was released at 8:30AM in the pre-market. It was pretty clear that the market did not like the data as “peak inflation” may take more effort to extinguish. The price action to close the week was also poor and a break of the 3900 area implies the June low at 3650 will be re-tested (at least).

Fundamentals Deteriorating

The third quarter is also shaping up to be a disappointment as companies are making pre-announcements with bad news. Eastman Chemical, Nucor and Alcoa have downgraded their outlook as demand destruction from higher rates is filtering through the global economy. However, the big news came on Thursday from FedEx that delivered their earnings a week early and reported that EPS came in at $3.44 vs $5.14 expected. The CEO said that their expectations are now for a global recession and are taking aggressive cost reduction efforts, including cutting CAPEX by $500 million. The company is also closing 95 office locations and will be deferring hiring. Will more companies follow their lead into 2023?

The earnings headwinds for Q3 are piling up and come from a very strong dollar, increasing labor costs, demand destruction from rising energy costs and central banks sucking liquidity out of the capital markets.  

A Strong Dollar Could Bring Out Sellers

When foreign currencies depreciate this quickly against the dollar, foreign investors holding dollar denominated stocks and bonds make a killing verses their domestic holdings. The dollar appreciation has been very strong in 2022 and may incent foreign investors to sell US stocks/bonds and monetize their foreign currency gains.

This is especially tempting to countries like Japan who have suffered a massive devaluation as they hold interest rates near zero. Now the dollar is worth 25% more in yen than it was at the beginning of the year, lifting the value of the fund’s assets. Selling some of those dollar denominated investments could allow the government to boost the yen and counter the currency’s depreciation.

And this could mean the next wave of sellers is manufactured from currency differentials. This relationship has the potential to create liquidity gaps in the stock market – like we saw with FedEx on Friday. Many foreign central banks and sovereign pension funds have large holdings in US stocks and bonds so it could get ugly if they all try exit within a short period of time.

The Bigger Picture

The chart below is of the S&P 500 ETF (SPY) that shows the top in January. The move down to the June low may be only the first wave down so the rally to August at $432 was counter-trend which means new lows for 2022 may be on tap over the next few weeks.

S&P 500 ETF  @kiscocap
www.kiscocap.com

The Bond Market

MBS Fed Holdings

One major thing that happened in the bond market this week was that the Fed has discontinued purchases of Mortgage Backed Securities (MBS). The rationale for buying MBS came about during the financial crisis to help re-inflate home prices now this process is working in reverse. The Fed will have to outright sell these securities if they want to reduce their exposure as maturities go out 30 years.

The graph below shows what the US Treasury yield curve has been doing since August 1st and you can see the bond market is pricing in more rate increases by the Fed. Notable is the 1YR tenor which is now touching 4%. This is a big move in a short amount of time and it will have repercussions for the high-yield bond market and companies that carry floating rate debt.

Yield Curve by tenor.  @kiscocap

Bond investors tend to be pretty good at pricing in risk as the high-yield bond ETF (HYG) below topped one year ago. Higher rates will be an issue for this sector in 2023.

Economic Data

  • Eurozone inflation rose 0.6% MoM in August, unchanged from the initial estimate.
  • The British Pound hit 37-year lows relative to the U.S. Dollar as new data stoked fears that the country is already in a recession.
  • Argentina hiked rates to 75% as their annualized inflation rate hit close to 80%.
  • U.S. consumer prices rose more slowly in August from a year earlier, but increased sharply from the prior month after excluding volatile food and energy prices, showing that inflation pressures remained strong and stubborn. The Labor Department on Tuesday reported its consumer-price index rose 8.3% in August from the same month a year ago, down from 8.5% in July and from 9.1% in June, which was the highest inflation rate in four decades. (WSJ)
  • Both the NY and Philly September manufacturing surveys reported this week are showing readings of contraction.
  • U.S. suppliers cut prices again in August, suggesting that a moderation in consumer prices could be on the way. The producer-price index, which measures what suppliers are charging businesses and other customers, fell 0.1% in August from July, following a 0.4% drop in July, the Labor Department said Wednesday. On a year-over-year basis, the PPI was up 8.7% in August from the previous year, down from July’s 9.8% increase.
Paul McCarthy, President of Kisco Capital, LLC

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Paul J. McCarthy III

President, Kisco Capital

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.