Morning Notes — Near-Term Outlook

Near term outlook driven by a calmer tone following reports that UK PM Truss and Chancellor Kwarteng are holding an emergency meeting today with the Office for Budget Responsibility (OBR).

August US headline PCE came in hotter than anticipated, up +6.2% vs. consensus for +6% forecast, but down from last month’s +6.3% reading. Core PCE (ex food/fuel) was also higher, up +4.9% vs. consensus and last month’s +4.7%. Today’s muted market reaction to a hotter inflation print reflects an understanding for the lagged nature of realized inflation data.

This morning, Fed Vice Chair Brainard reiterated the Fed’s commitment to inflation control, but was the first official in this cycle to highlight “the effects on activity and price setting in different sectors may occur with a lag.”  Brainard also took a small step back from the hawkish Fed message to acknowledge the tightening of financial conditions from dollar strength and noted that real yields in almost all maturities are now in positive territory/restrictive.

Other US data was generally softer than expected with September Chicago PMI falling into contraction territory and a downward revision in September final Michigan consumer sentiment.

Eurozone CPI came in hotter for a fifth straight month, but not quite as bad as feared and China PMI’s came in mixed. China also announced a relaxation of floor rates on mortgages for first home buyers, while the PBOC injected large scale liquidity ahead of the Golden Week holiday.

Geopolitical headlines are in focus as the US and EU prepare additional sanctions on Russia in response to Putin’s planned annexation of four Ukraine territories.

The S&P 500 (SPX) is in deep oversold territory and just beyond levels we saw prior to the +17% summer reflex rally. Equity sentiment is at record bearish extremes and large non-bank cash holdings provide a major backstop for both bonds and stocks. Correlation between the two major asset classes has converged toward 1 and we expect an imminent reversal to occur in both markets simultaneously.  A reversal in the SPX will likely be preceded by a short period (1-2 days) of momentum dispersion or a capitulation trade with over-owned names cascading lower.  The former path is preferred because it’s more orderly and allows some time to add equity exposure.  The capitulation-based path is easier to identify and will likely include an intraday breach of strong technical support at ~3500 before reversing higher. Terminal rate expectations have been the dominant cross market for equities since late-Q1 and any reflex rally will likely follow a lower terminal rate.  The Fed’s updated dot plot from the September 21 meeting suggested March’23 rate ceiling of 4.50%.  Terminal rate expectations peaked on September 23 at 4.67% and have mean reverted to 4.46% today.  The distance below or above 4.50% will likely determine the near-term direction for the SPX.