The Week Behind 

In a week characterized by crosscurrents, major indices leaned slightly lower. With respect to inflation, while PPI continued downward, reinforcing CPI, hotter-than-expected U.S. Retail Sales provided some contrary data. Otherwise, the markets had to contend with a missile incident in Eastern Europe and an incredibly hawkish FED President. The DOW closed the week flat. Despite finding support and bouncing off its 90dSMA, the S&P finished down ~0.69%; the NASDAQ dropped ~1.6% as treasury yields found some support to end the week. 

Highlights

• October PPI reinforced the message out of CPI: inflation may have peaked and has room to fall further. 
• Preliminary evidence suggests the missile explosion resulting in two Polish casualties will not warrant activation of NATO Article 4.
• U.S. Retail Sales came in above expectations, which, despite CPI and an abysmal earnings report from Target (TGT), suggests there may still be goods-related inflation in the economy sustained by strong consumer spending.
• FED President Bullard stated interest rates are not yet “sufficiently restrictive” and called for a Fed Funds Rate between 5-7%. 

Two Messages: The Short-End and the Long-End of the Bond Market

Since CPI, broadly speaking, yields have traded lower. However, they have fallen further on the long-end (5YR to 30YR) than the short-end (1M to 2YR). Let’s focus on the messages the bond market is sending via the US10YR and US2YR as the spread between the two reaches its most inverted level in over forty years. As a reminder, when bonds are bought, the price goes up and the yield goes down: inverse relationship.

This tightening the cycle, the US2YR (blue) has frontrun the Fed Funds Rate (red). Typically, the spread between them is 25-50bps. At ~4.5%, the bond market is expecting a terminal Fed Funds rate of 4.25 – 4.75%. Currently, Fed Funds is 3.75% – 4.00%. Consequently, assuming markets look forward 6-12 months, the bond market has priced-in another 25-75 bps and expects the FED to make good on that. Given that expectation, there is no institutional rush to buy the US2YR, which is why its yield remains elevated.   

Now, let’s take a look at the US10YR. It is a bond-investor favorite for hedging against slow growth because it guarantees yield during difficult periods for stocks. However, high inflation is a major concern because the real return will be negative every year inflation is greater than the yield you locked-in. Courtesy of a restrictive Fed Funds rate, a handful of earnings misses, downward revisions, and further cuts expected, consensus is that growth is slowing. Courtesy of a meaningful drop in CPI and PPI, there is a compelling feeling inflation has finally peaked. With these two conditions met, the institutional demand for the US10YR begins to pick up, explaining the drop in yield. 

The bond market is using the US2YR to tell us to expect additional hikes and the US10YR to expect slower growth. In other words, the bond market is signaling that the FED is hiking into a period of slowing growth: a recipe for recession. This feels like the first time where we can clearly see, no room for arguments about how either is priced, how the US10YR and US2YR work together to predict a recession, which leads me to believe it is finally worth listening to.

The Week Ahead

In observance of Thanksgiving, the most underappreciated holiday in the U.S., it is a shortened week for stocks. Thursday is off. Friday is a half day: markets will trade from 9:30AM to 1:00PM. 

Tuesday is a big day for retail. Best Buy (BBY), Dick’s Sporting Goods (DSG), American Eagle (AEO), Burlington (BURL) all report. Each should provide more information on what to expect going into the holiday quarter. Otherwise, on Wednesday, Deere (DE) reports. This industrial company is known for its big-rig agricultural equipment but also manufactures equipment necessary for building roads. It could be a major 2023 winner as infrastructure stimulus hits company P&Ls. 

With Thursday off, Wednesday is stacked with economic reports: initial and continuing jobless claims, PMI, UMich consumer sentiment and inflation expectations, new home sales, and the FOMC minutes. Of all the data hitting the tape this week, I suspect the FOMC minutes will be the most consequential to price action. FOMC minutes do not tend to change minds. Often, it reinforces the current trend. Consequently, I expect it to be bullish. While the other reports are worth nothing, I think it unlikely any new, material money-moving information lurks within them. 

BRK Buys TSM

Updated 13Fs, SEC-mandated filings for institutional investors, revealed Buffett’s Berkshire Hathaway (BRK) initiated a $4.1B position in Taiwan Semiconductor (TSM). Now, while it only makes up 1.39% of BRK’s overall portfolio, my biggest takeaway is that this suggests the mind trust at BRK does not foresee a conflict between China and Taiwan. These are some of the smartest minds in finance. While this does not affect my current stance on the semiconductor space, which is in the early innings of a shift from bearish to neutral, it does make me more comfortable further delaying my purchases in aerospace-defense stocks and more interested in stocks with value to be unlocked once the locks come off the Chinese economy.