🗞 Open Book Test

WHILE YOU POUR THE JOE… ☕️
I Don’t Know Rick

Here’s the thing: Fed Chairman Jerome Powell has just said that the economy is “Strong,” so they are in no hurry to cut interest rates further.

However

During the last FOMC meeting, the economy was so weak that he deemed it necessary to enact a 50 basis point cut 📉, the most aggressive shift in over 16 years.

So, which is it, J? Don’t ask me. The data speaks for itself, but markets won’t budge until everyone cares.

And it looks like someone is starting to care; his name is the bond market.

Speaking of which, let’s get on with today’s email 📧…

CRASH COURSE ON MARKETS
We’re Gathered Here Today

All asset classes have been rounded up today to give you one market view.

Look, we post our views every single night on our Twitter account to show you what we think such price action means for the broader narrative and theme of the economy.

But you’re here for a reason—you’re here to get an in-depth look at what we do, right?

Thank you, so here we go:

Credit Markets & Commodities

Let's recap here: We have the Secured Overnight Financing Rate (SOFR) versus the Overnight Index Swap (OIS). Their spread has been spiking, as you can see.

And that means

Credit markets are tightening. This usually happens when banks won't lend to each other, knowing that their balance sheets may be holding some toxic asset, aking loans more risky.

Whenever this happens, the overall economy is then sure to run into similar liquidity and credit issues 🔥, so I'd watch out for that in the coming quarters.

Other ways to check is through the bond markets, so here's the $TLT ETF that everyone seems to be familiar with:

It may not look like much by itself, but you have this arch formation over the past week. Let me give you a timeline to help you make sense of it.

1. Presidential election: Bonds sold off to reflect the renewed inflation theme, driven by tariffs and Trump's desire for a lower dollar to boost domestic manufacturing and exports.

2. Everything Rally: The ensuing days were a bit crazy. We had an “everything rally,” bonds fell to renew inflation themes, and Bitcoin reached over $90k for the first time ever. Cyclicals and commodities did well, too.

3. Second Rally: Now bonds are rallying again, meaning inflation themes are coming off.

But

If inflation comes off, given that gold and oil prices have also retraced, then we think the scenario that will replace inflation is recession.

Here we go with another implication between gold and oil.

Historically, you’ve always heard that gold goes up during inflation, right? But then, oil is also supposed to go up on inflation.

So why the divergence?

It’s because one is calling for inflation and the other for recession, so either one is right, or we’re headed into stagflation (no growth with inflation).

During the past 4 years, gold and oil correlations have been positive, meaning both commodities shook hands on the fact that inflation was coming down thanks to the Fed.

This time, though, as gold took off while oil was left behind, the narrative is no longer inflation; it’s stagflation.

However

The way bonds (blue) below stopped tracking oil (red) could give you the answer everyone is looking for here.

Is it recession or inflation?

There was moderate inflation for 2016-2019; as you can see, oil prices in red trade within a channel were without too many shocks; hence, bonds in blue didn’t move that aggressively either.

Then, from 2020 to 2024, we start with a wide divergence (when the world thought we were all going to die from the flu) and then a four-year convergence, which means normalizing economic environments again.

So, let’s zoom in to see what other measures can tell us about today’s relationship 👀.

A correlation bottoming between oil and bonds means that a divergence is coming between these two.

That means two things:

1. If oil rallies back into the $80s—$90s, bonds will have to sell off accordingly to reflect higher inflation and busier economies.

2. If oil sells off further, then bonds rally to give us lower yields as a knee-jerk reaction to more recessionary risks.

Of course, as gold sells off, I think the evidence is starting to point toward case #2 here. There is one more middleman between this whole mess who can guide us into the future.

Is the US dollar rallying hard for no apparent reason, or is there one? 🤷‍♂️ 

Honestly, I have no idea, but I’ve got a couple of these. You know how China is getting rid of US debt (bonds) to buy gold and collateralize it for more stimulus?

Well, all those dollars have to go somewhere when they buy gold, and since gold is probably coming out of dollar-denominated economies, the market could be saying, “Hey, look at all these central banks accumulating dollars; they must love the thing!”

But then Trump is going to pull the rug and devalue the dollar because of the $1 trillion of debt interest payments (bigger than defense and healthcare budgets) and to help revive manufacturing.

China knows that would be good for our economy, so they could raid the dollar higher to stop us from getting our house in order, but again, I’m honestly lost with the dollar.

Okay, that was a handful, wasn’t it? Let me give you a recap so you can move forward:

1. Gold is selling off, telling us inflation is canceled, and low oil prices agree.

2. Bonds are not sure yet, as they fell this week to call for higher yields, but a recent rebound might signal they’re starting to get it.

3. Due to negative correlations, either oil sells off some more to send bonds higher (recession) or oil rallies to bring bonds lower (inflation)

I think that as long as the dollar remains artificially strong, we’re going to see bonds and oil play a role in the recession theme. If a major player comes in to break the dollar, then you already know what the signal would be through bonds and oil.

Ultimate Hedge

The small cap index, the Russell 2000 through $IWM, is going to be your best enemy.

By that, I mean your best shot. 🎯 

It’s no coincidence that Tom Lee and a bunch of retail investors got excited about $IWM in recent months. Everyone knows that no matter if we get a recession or inflation, small-cap stocks will suffer due to their concentrated domestic-only exposure.

They can’t diversify away from costs, so go against it and you should be fine.

By the way, notice how it tracked bond prices in orange and then suddenly diverged? Who will correct the most? 🫰 

 TRADE OF THE WEEK
Play Both Sides

After digging through our results for the services PMI from our previous post, we landed on a potential trade to take on from the retail trade industry.

Remember, that was one of the industries that pushed the most expansion readings in the services sector, so we decided to keep that in mind as we moved into the week to find trade ideas.

Here’s what led us to confirm the sector as being a good one to look into with a long bias:

Taking it from the forward P/E ratios and earnings per share (EPS) growth forecasts, we want to select the industries that command a premium to peers.

These are the restaurant names and apparel & accessories, so we dug and found two worthy stocks to look further into.

In the same way, Floor & Decor calls for the most premium and EPS growth, so it makes sense to keep it on a watchlist for potential longs.

Then, Tapestry stock suddenly fell near the bottom of the list, even though it trades near its 52-week high.

I’ll tell you why that is, though

The company was supposed to merge with Capri Holdings, and that would have brought enough growth into Tapestry to justify a high stock price despite low current growth and discounted earnings.

Then, the deal fell through 📉, and Tapestry's hopes of remaining at its highs might fade into history, making for a great short, in my opinion.

That's an idea, though. We now need to check the statistics of the trade setup and whether a long/short equity spread is correctly set up.

We have the following breakdown starting with correlations, which you should be familiar with by now.

This deviation, a multi-year one, means that it must revert back to the mean, and either Floor & Decor stock rallies or Tapestry stock sells off.

Fundamentally you already know which is more likely to happen, so here’s the entry and justification.

The spread ($FND - Hedge Ratio * $TPR) is charted above and is now sitting at a major deviation, but it is still showing positive for stationarity tests. 🙌 

In English, the rocket took off but ran out of fuel before making it to space. The last time we checked, gravity was still on, so back to Earth it goes.

That hedge ratio above is a 1.98 (round it up to 2), meaning you need to short 2 shares of Tapestry for every 1 share you buy in Floor & Decor, this way you will be hedged properly from market risk. ✅ 

NOW GO AND MAKE IT HAPPEN
House of Money

It’s here; get inside, it’s fun inside. Not Mickey Mouse’s clubhouse, it’s the house of global macro hedge funds.

Today’s book recommendation 📖 will walk you through how these managers operate and the importance of keeping track of all markets every day, such as we just did above, so that you’re never caught by surprise.

To your success,

G. 🥃