Top Watch

Top Watch

Crude Oil

A lot happened this past week as we saw a war escalate between Israel and Iran and the Fed Chair also conceded on Tuesday that rates may not change in the near-term. A significant admission by Powell and it may have been prompted by commodity prices and oil in particular which should begin to price in the potential for a supply interruption. You can see that oil prices in the adjacent chart reacted directly to the attack and I wouldn’t be surprised to see $100 in the summer months.

As you know, oil prices are ground zero for inflation. Everything we buy needs to be transported (car/rail/truck/ship) so higher oil prices will transmit higher prices to consumers (with a lag). Unfortunately, I don’t think this risk is going away anytime soon. And if oil does trend higher then we may get that slowdown in growth or a recession that the Fed needs to cut interest rates.

The Inflation Outlook

Below is a chart of inflation expectations over the next two years. You can see on the far right that the retreat we got at the end of last year has reversed course and is pointing towards higher levels. This reflects the higher than expected inflation reads we got in Q1 and can affect consumer purchasing behavior.

2Yr inflation expectations.

For perspective, I have a chart of the CPI in the form of an index below to better comprehend how inflation erodes purchasing power. It is always good to look at more than a percentage change from the monthly data as it is easy to lose perspective that price are heading higher even if the CPI is at 2%.

CPI over time.

Let’s review. On the far left in 1947, this index read 22 and rose to 38 by 1970. After the United States came off the gold standard in 1971, this index rose to 80 by 1980. If we fast forward to pre-COVID, this index stood at 260 and is now at 312 which means prices are 20% higher today than pre-COVID. We have not seen monthly CPI reports go into the negative which means this index keeps pushing higher. So, how does the Fed have any latitude to cut interest rates?

The Bond Market

Corporate debt has had a great year and high yield bonds are now trading at some of the tightest levels in over 30 years. Great for issuers but it also shows complacency by investors that are not pricing in the risk of higher for longer interest rates.

Below I have the chart of the 10Yr Treasury yield and you can see in the upper right-hand corner that 10Yrs have been rising since the end of lat year. Eventually, I see the long end declining to the 4% or lower region on a flight to quality (something bad will happen soon) but only after this leg higher begins to retreat. Maybe 10Yrs touch 5% in the coming months but we will have to wait and look for evidence of that upside momentum waning before retreating lower.

10Yr yields.

What About Stocks?

We are in the heart of earnings season so the stock market will be looking for clues this coming week from CEOs on their outlook for the rest of the year. One notable was that some semiconductor companies are downgrading their outlook on growth so that will cool the advance for this leading sector.

For the S&P index, there is an ongoing reversal to the downside in the chart below as you can see the sharp drop to the 21EMA (green line) at $493. Also, the momentum indicators on this weekly chart have rolled over to the downside so I would expect selling pressure to continue in the coming weeks. Very possible we get bounce off of the 21EMA next week but stocks tend to revisit previous highs and in this case that would be the January 2022 high at $480.

S&P 500.

There is another Fed meeting at the end of this month and it will pretty significant as the markets are beginning to reflect the reality of persistent inflation, rising commodity prices and Federal deficits and spending programs topping $1 Trillion.

Paul McCarthy of Kisco Capital, LLC

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Paul J McCarthy III CFA

President, Kisco Capital

Paul McCarthy

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