Fed Up

Success! The Fed is done - even if they don't realize it. Inflation expectations, and with them long rates, have peaked and are in full reverse. The breakdown in Copper/Gold as much as told you so. More importantly, inflation fears have been trending down since the market's focus shifted to fear of impending recession. The inverted 2s/10s Treasury curve is now evidence enough for me to say that the much-needed growth slowdown is finally here.

Notice I didn't say the Fed is finished hiking. As the Pavlovian Puppets of the risk markets, they will continue to raise rates in order to 'fight the last war' that resulted from their previous ill-advised stimulus excesses. By slavishly directing the economy with their 'data dependent' rulebook, they will be unable to restrain themselves when the 8%+ CPI prints this week.

But even the hapless, group-thinking Fed-iots should begin to change their tune with the newest market signals. Gasoline prices, a huge driver of headline inflation, are now heading lower. Even Powell & Co. will be sensitive to these price signals. The gas supply squeezes on Europe from the Russian energy chokehold are sending recessionary shockwaves that have helped tighten financial conditions. China is on the verge of another Covid shutdown. Currency markets are now in disarray as policy gaps widen, adding to the disinflationary pressure. The Fed is being helped by Putin and Xi without even having to ask them. All the necessary ingredients for a dovish shift are falling into place.

Much is made of the inflationary effects of the Chinese covid shutdowns on global supply chains. But the festering real estate meltdown is a news story that has been consistently embargoed by authorities. Beijing has begun to transfer funds to local governments under the disguise of 'infrastructure'. Local governments are using those funds to fill potholes in their budgets created by a sudden collapse of development fees due to a development flash freeze. Shoring up debts created in a prior cycle doesn't create a whit of future economic growth. China, now in economic repair mode, won't suddenly rebound as they have in prior cycles.

In the last bull market, copper prices were a backdoor way to play the 'green' economy that drove much of the growth stock mania. Spurred by Goldman Sach's Jeff Currie, hyperbolic call for a super-cycle, the commodity bulls piled into metals used in the EV space. But the demand for metals is more dependent on Chinese growth than the green economy. There may be 50 pounds of copper in a Tesla, but there is a helluva lot more in a Shanghai condominium. Dr Copper is prescribing a bitter pill now.

Copper/Gold Ratio

Now that the liquidity tide has receded, the naked swimmers are being revealed one by one. The earnings season starts this week. Companies have so far passed along the cost increases that resulted from the supply shocks and many earnings reports should be a bit better than feared. A combination of a strong consumer balance sheet and negative real rates should cushion the earnings blow. Certain specific situations will be ugly - $GPS guided lower today - but they will be offset by companies with pricing power - $PEP beat and raised and $AAL just guided higher.

So a combination of a Fed perceived to be 'done' and a better-than-feared earnings season is a perfect setup for a counter-trend rally, if not a durable bear-market low. Last week I talked about the market internals such as momentum, volume, and breadth being oversold enough to support such a rally. The catalyst. as I have also been consistently saying, is enough negative news to change the attitudes of investors on their expectations on the path of interest rate hikes. I think we're there now.

The major remaining negative for the large multi-national companies is the foreign-sourced earnings stream. The strong dollar and the weaker economic performance of global economies mean downward revisions are still coming. But this is good news for U.S. domestic companies that tend to be in the small-cap space. The chart below is encouraging. As we saw in the post-Covid rebound, Smaller companies usually outperform in a recovery environment. Large Tech companies seem especially vulnerable to current global weakness and are over-owned in many passive portfolios. Focus on domestic-oriented small caps in your selection decision.

Russell iShares: Small/Large Cap Relative Price

A rebound in risk markets, while playable, will be tricky to navigate. And there can be no assurance that the underlying issues, especially energy prices going into the winter, are completely dealt with. The markets have experienced a sudden shock, but it's more like a valuation reset as opposed to a full-on recession-driven bear market. The $5+ Tn declines in the technology sector are certainly nothing to dismiss easily, but the consumer spending effects of the massive portfolio drawdown have been muted. The vaunted 'wealth effect' has simply meant less demand for Bitcoin, not real goods and services. Relief from gas and food inflation could easily translate into a temporary rebound in growth expectations in the second half of the year.

The markets will need to be vigilant to supply shocks as the deglobalization and resource constraints exposed by the post-Covid rebound demand surge will constantly be with us. We are not completely out of the woods on inflation yet, and the bond market, after this current rally runs its course, should remain in a secular bear for many years to come. Yeah, I still hate bonds, but I can see a 2.50% 10Yr in the cards should the Fed turn less hawkish. That helps growth more than value.

So is the next move a 'buy-the-news', post-earnings bounce led by growth stocks? Seems like a good bet. A Fed that signals a 'dovish hike' will be the key. As for all the bad news that we have been getting - I think the market is finally Fed up.

Risk Model: 1/5 - Risk Off

Don't look for this model to get ahead of the game and predict a rally. AAII Sentiment lags on the recovery, Copper/Gold is a mess and the VXV is in a bearish rising trend that I need to see broken definitively before getting long-term bullish (chart below). Should the Fed signal a less hawkish policy set, the VXV should break down sharply. Watch this carefully over the next few weeks.

CBOE: 3 Month Volatility