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Bond Vigilantes: Fed Needs To Get Ahead Of Inflation
Recent inflationary developments increase the chance that the FOMC will vote to raise the federal funds rate at this week’s meeting. Today, Ed and Elias examine the hawkish shift and explain why it suggests that a 25bps rate hike this week is more likely than not. … Also: The Fed underestimated the persistence of the 2021-22 inflation shock and won’t be inclined to do so again—lending a hawkish overlay to the Fed’s deliberations. … And: The bond market appears to think a July rate hike is warranted, flagging broader inflationary risks than those represented by energy prices alone. … Ed reviews “Odysseus” (+ +).
US SECTORS CALL: Follow The Money
The S&P 500 has been holding up around 7,500 as the war in the Middle East escalates. It closed at $7411.98 on Friday, just below its 50-day moving average (chart). Alphabet and Tesla both reported great Q2 revenues on Thursday. Yet both stocks were crushed, down 6.9% and 14.5%, as free cash flow turned negative for both. Investors have decided that AI capital spending is a high, known cost with an unknown ROI. However, the hyperscalers' negative free cash flow has boosted the positive free cash flow of semiconductor companies. Nevertheless, semiconductor stocks gave back more ground this week. Even so, the iShares Semiconductor ETF (SOXX) closed Friday at $527.01, still 32% above its rising 200-day moving average (chart). We downgraded the S&P 500 Information Technology sector to market weight on December 7, 2025. We continue our overweight ratings on the Energy, Financials, Health Care, Industrials, Materials, and Utilities sectors (table). Here's what has gotten our attention recently among some of the sector trades: (1) Transportation: On the fast track. Dow Theory remains bullish. The Dow Jones Industrials Average and the Dow Jones Transportation Average remain in record-high territory. The S&P 500 Industrials sector (which includes the Transportation industries) is up 17.3% ytd, second only to S&P 500 Energy among all sectors. The Transportation composite is at a record high despite high fuel prices (chart). Analysts are marking up rail revenues. The consensus now expects S&P 500 Rail Transportation revenues to grow 6.6% in 2026, up from 2.9% in March. Rail forward earnings, which has been flat for the past four years, is now rising to record highs (chart). The rebound in rails coincides with the data center construction boom. Rails haul the materials and equipment needed to build data centers. The risk is valuation. Rail Transportation's forward P/E is at a record high of 24.3 (chart). Higher oil prices add a fuel cost increase the likes of which the sector has not faced since 2022. (2) Information Technology: Spending, not burning cash. Alphabet raised its 2026 capital spending guidance to $195-$205 billion on Wednesday, up from $180-$190 billion a quarter earlier. Investors sold the stock. They ignored the other half of the report: Google Cloud revenues grew 82% y/y, and the backlog reached $514 billion. This is not spending in search of demand. The other four hyperscalers (Amazon, Microsoft, Meta, and Oracle) report over the next two weeks. Analysts expect the five of them to spend roughly $750 billion this year, up from around $600 billion estimated in January. Lots of that spending is on semiconductors. The semiconductor ETF (SOXX) is up 75.0% ytd (chart). The Magnificent-7 ETF (MAGS) is down 4.3% ytd. The S&P 500 Semiconductors forward revenues per share is up 103.5% ytd (chart). The rising forward profit margin lifted the industry's forward EPS by 161.3% through the week of July 24. The S&P 500 Semiconductors forward revenues per share is up 103.5% ytd (chart). The rising forward profit margin lifted the industry's forward EPS by 161.3% through the week of July 24. (3) Financials: Spending big on fintech. Financials have lagged this year, up 2.8% ytd against 8.3% for the S&P 500. They have moved higher recently. The sector is up 4.9% mtd, while the index is down 1.2%. The large banks are near record highs despite the rising odds of a Fed rate hike (chart). The sector is spending heavily to rebuild its own plumbing. The Depository Trust and Clearing Corporation began limited production trades of tokenized Russell 1000 equities, major ETFs, and US Treasuries this month, with a full commercial launch scheduled for October. Goldman Sachs, JPMorgan, BlackRock, Vanguard, and the NYSE are participating. Technology budgets at the large banks are rising fast. That spending is a cost today but a higher-margin story tomorrow. The current forward profit margin is at a record 21.8% (chart).
ECONOMIC WEEK AHEAD: JULY 27 - 31
The S&P 500 closed Friday at 7,411.98, down 0.6% on the week, while the Nasdaq fell 2.1%. Oil was the dominant story: The price of Brent crude jumped 7% Thursday to settle at $100.69 a barrel, its first close above $100 since May 26, after Yemen's Houthi militants claimed strikes on two Saudi oil tankers in the Red Sea (chart). President Trump said the US would hold Iran responsible for any further attacks on shipping, threatening "major military punishment" against Tehran. Big Tech's earnings kickoff was depressing. Both Alphabet and Tesla fell sharply after reporting negative free cash flow. Looking ahead, the calendar is jam-packed this week with lots of earnings reports. The monetary policy committees of the Fed, the Bank of Japan, and the Bank of England will be meeting. Four more Magnificent-7 companies are set to report. Q2 GDP and June PCED inflation readings both are due Thursday. Here are the key economic releases most likely to shape investors’ thinking this week: (1) Fed Policy & Global Central Banks. The FOMC's two-day meeting concludes Wednesday with Chair Kevin Warsh's press conference to follow. The federal funds rate futures market is signaling two rate hikes over the next 6-12 months (chart). The June meeting’s Summary of Economic Projections showed nine of 19 officials penciling in a hike this year. This split raises the degree of dissention we might see at the July meeting whether the committee votes to hike or to hold. The Bank of England (Thu) and the Bank of Japan (Fri) both are expected to hold their respective policy rates steady (chart). (2) Earnings. Four Magnificient-7 companies report earnings this week: Microsoft and Meta report after the close on Wednesday, followed by Apple and Amazon on Thursday. Collectively, the four companies account for about 17% of the S&P 500’s market capitalization. The consensus of analysts’ estimates now implies aggregate Q2-2026 operating EPS growth for S&P 500 companies of 35.8% y/y, up from 22.9% a week earlier (chart). But 35.8% is a misleading figure due to the distortive effects of mark-to-market investment gains in some Mag-7 companies. Given how the market punished Alphabet and Tesla for reporting negative free cash flow, all eyes are on this week's Mag-7 reporters. (3) GDP & PCED Inflation. The advance estimate of Q2 GDP (Thu) follows a final Q1 reading of 2.1% annualized growth. The Atlanta Fed's GDPNow model had Q2 tracking at just 1.7% as of July 17, with its next update due Monday (chart). We expect the preliminary estimate to come in closer to 2.0%. Business investment continues to lead. Final sales to private domestic purchasers should be strong. June's PCED (Thu) follows May's hot readings of 4.1% y/y headline and 3.4% core, the highest since 2023 (chart). The Cleveland Fed's Inflation Nowcasting model projects June's comparable rates easing to 3.65% and 3.33% y/y, with headline PCED falling 0.12% m/m. This week's Houthi attacks and Brent's move back above $100 a barrel threaten the recent disinflation trend. (4) Employment. The next initial claims report (Thu), covering the week ended July 25, follows last week's 187,000 print, the lowest since 1969. That represented a four-week average of 207,500 (chart). Layoffs remain low.
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