The Bond Market Delivered the Verdict, and It Isn’t Pretty
Investors are sorting out the ramifications of an eventful Wednesday.
The Fed held rates as anticipated but proved more hawkish than feared, and the two big earnings reports raised more questions than they answered.
Futures are drifting higher after the punishing session, which is the market pausing rather than resolving anything.
The Bond Market Does Not Believe the Fed
Three members of the FOMC dissented in favor of a quarter-point hike, which is one more than expected. Fed Chair Kevin Warsh made several optimistic statements about eventually reaching the 2% inflation target but declined to signal anything about the path ahead.
Traders are drawing their own conclusion. According to the CME FedWatch tool, the odds of a quarter-point hike by the September 16 meeting are now 63.2%, up from 50.6% a month ago. Looking ahead to the December 9 meeting, the odds of at least a quarter-point are around 85%. Investors have decided a hike is coming this year and they are trying to figure out when it will happen.
Long-term bond investors are sending the same message. The 30-year Treasury yield climbed to 5.23%, the highest since around 2007, while shorter-maturity yields rose as well. The retaliatory strikes against Iran that ended the brief pause are not helping, and Brent crude is trading roughly $15 above its pre-war level.
This action raises the specter of the most feared issue in economics, which is stagflation. The hyperscalers that have been powering economic growth are facing increased pressure, and rising long-term yields are a persistent headwind. No single catalyst resolves the interest-rate issue, and rising rates raise the cost of everything the market is currently trying to finance at higher rates.
Reports Split the Hyperscalers
Microsoft ($MSFT) is rallying after beating on both lines. Barclays trimmed its price target to $512 from $545 while keeping an Overweight rating, citing better Azure and Office growth, with no negative surprises on the capital spending outlook or free cash flow targets, but it is still concerned about valuation.
Meta Platforms ($META) is sliding after losing about 10% in after-hours trading. Revenue grew 28% and beat expectations, so the business is performing. Earnings missed by roughly 14% because the spending is now hitting the income statement rather than sitting in a guidance range.
The balance sheet detail deserves attention. Meta expects capital expenditures around $137.5 billion this year, which analysts think pushes it into negative free cash flow in the second half for the first time since the 2012 IPO. Next year’s projections rise to $174 billion in spending and some analysts think that number is low. Deutsche Bank sees up to $215 billion and Raymond James projects $280 billion. Long-term borrowings reached $83.7 billion at the end of the second quarter, up from almost nothing until 2022, and that figure excludes off-balance-sheet debt tied to data center leases in Louisiana and Texas.
The 40-year bonds Meta sold in May have fallen enough in price to push their yields near 7%. That is the financing cost problem in a nutshell.
Evercore ISI removed Meta from its top pick list while maintaining an Outperform rating and cutting its target to $820 from $930, citing rising AI spending, limited visibility on future capex, and no clear path to monetizing it.
Same industry, same spending question, and the analysts are now separating these companies based on whether the spending can be defended. The AI trade is far from the single monolith it once was a year or so ago.
Amazon ($AMZN) and Apple ($AAPL) report after the close Thursday, which gives us two more insights into the capital spending issue. As we have seen, these reports are about much more than simply beating published estimates.
Momentum Chasers Are Taking Damage
The poor performance of technology is causing substantial damage to some of the investors who led the momentum chase. The Financial Times reported that Situational Awareness, the roughly $20 billion fund run by Leopold Aschenbrenner, is seeking new capital after losses in AI stocks. The fund has approached existing investors and lenders, and some investors have been offered the option to buy assets directly from the portfolio.
Situational has a concentrated position in the data center and power sector. That is the same group that has been going bidless on days like the past two, falling much further than any change in fundamentals would seem to justify.
This is what liquidity-driven selling looks like. A large holder who has to sell does not wait for a good price, and the stocks that get hit hardest are the thinner ones where the bids disappear first. It is worth remembering that Situational was among the institutions that took a large piece of the SK Hynix ($SKHY) offering earlier this month.
Game Plan
Despite the doom and gloom out there, I am growing increasingly optimistic about the trading opportunities developing from this price pressure. However, my optimism does not extend to bottom fishing broken stocks.
The names destroyed over the past two weeks will need months of repair work before they can sustain an uptrend. Bounces in those charts are for traders with tight time frames that can’t resist buying substantial pullbacks. They are not for anyone building large positions in new leadership.
What I am looking for are good entries in stocks that have shown relative strength through this selling and are positioned for a favorable reaction to their own earnings reports. A stock that held up while the market was down 3% is telling me something that no amount of fundamental analysis will tell me. The small and mid-cap earnings calendar starts filling up shortly, and that is where the next batch of opportunities is going to come from.
Relative strength first, then the catalyst. That sequence keeps you from the game of catching falling knives and safes.
Position: None
