@theMarket: Inflation Jumps, Stocks Dump

This week saw three major changes in the financial markets. Bond yields fell, AI stocks plummeted, and inflation reared its ugly head. Markets didn't take that well.

 

Let's start with inflation, since for some reason, the higher Consumer Price Index (CPI) and Producer Price Index (PPI) for September surprised the markets. Our readers were prepared for that, but I guess most of the public doesn't read my columns. In any case, yes, the data was much "hotter" than the market expected.

 

The PPI gained the most in four years. The last time it soared 1.3 percent from the previous month was back when Russia invaded Ukraine. The CPI was also higher, indicating that the annual inflation rate has now accelerated to 3.7 percent. As you may guess, both indexes rose on higher gas and diesel prices due to Trump's war on Iran.

 

Next in line was the rapid decline in the technology index, represented by the Nasdaq, which dragged the whole market down with it. The culprit, however, was not inflation, but rather worries over AI financing. Some of the second- and third-tier AI players in that space are highly leveraged. Several have spent or borrowed 3 or 4 times their annual cash flow.

 

Higher inflation, fears of rate hikes, and the spike in bond yields have led investors to worry that many AI companies may be over their heads in managing their debt load. As if this were something new, but suddenly it matters. The rout that has followed belies the almost 4 percent decline in the overall tech index. Many AI equities suffered double- and even triple-digit losses.

 

Given that the largest 10 companies in the S&P 500 are tech or AI centric and they represent almost 50 percent of the index, when technology falls, so does the S&P. However, the benchmark index finished the week down less than 1.5 percent thanks to some unforeseen support.

 

It should have been worse, but that's where the decline in bond yields came in. You might think that with such strong inflation numbers, bond yields would have soared, while prices declined. They didn't.

 

Yields dropped like a stone. I suspect the reason has something to do with a shift in who is buying and selling U.S. Treasury bonds. The historically staid crowd of insurance companies, pension fund managers, sovereign funds, and the like is still there, but now invest shoulder to shoulder with those masked villains: the bond vigilantes.

 

Who are behind those masks? Hedge fund managers. Hedge funds now represent at least 12 percent of the trading in the recently "hot" government debt market. Oh, and by the way, they also hold big positions in AI stocks.

 

By CPI Wednesday, bond yields were at the top of their risk range and technically overbought. Unlike traditional bond players, hedge funds pay attention to this, as does U.S. Treasury Secretary Scott Bessent. The CPI data was announced. Yields shot up and then bang! That was the signal traders needed to sell (cover) their profitable bond shorts and buy back bonds with both hands (possibly with a little help from ex-hedge fund manager Bessent and his Treasury).

 

In minutes, the narrative changed. Gone was the inflation risk; in its place was a dash to the safety of government bonds amid AI credit-risk worries. The subsequent sharp sell-off in AI equities, likely aided and abetted by these very same hedge funds, just added to the trade — traders seeking better credit investments piled into good old USA "Govies."

 

That move supported the S&P 500 and Dow indexes somewhat. As for the markets over the next two weeks, as I wrote yesterday, third-quarter earnings better be good. Despite everything the administration is doing to support the markets, I suspect less-than-stellar results from AI companies will lead to more downside for stocks.

 

With oil almost back to $100 a barrel, the downward pressure on equities is building. That is not what the administration wants with just three weeks to go before the midterms. Of course, if things get truly dicey, the president could always throw in the towel and make nice with the Iranians. It has worked before to bolster the markets; it might again.