The Fed Continues To Hold The Key

The Fed Continues To Hold The Key

May 01, 2024

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Since the days just preceding Tax-Day, April 15th, the US equity market has been on a tear upward that started back in October. The US Treasury bond markets seem to have been the reason for this. After the Fed raised interest rates seven times back-to-back, to stave off inflation, the interest rates rolled over. But since the beginning of the year, the bond market has not been having such a good time of it, giving back the drop in interest rates. The bond market has been reversing the move from 5% on the 10-year in late October down to 3.8% at the beginning of the year. Why would the interest rates top out at 5%, drop back down to 3.8% and then start to travel back up? I believe that the move down in rates was the market thinking that the expected effect of seven rate hikes would be to ensure the economy was not staying overheated and that inflation would be kept in check.

What was not considered was the monstrous amount of cash sloshing around on the sidelines that continues to fuel consumption. The result being stronger than expected continued economic growth and inflation numbers everywhere. This changed with last week’s GDP number that came in at +1.6% when it was forecasted to be +2.5%, while inflation numbers continue to be stickier than hoped for. This presented the worst possible scenario; slow economic growth coupled with stubbornly high and not diminishing inflation. The fancy word for this is “stagflation.”

The market seemed to know that inflation was going to remain stubborn as the stronger than expected CPI and PPI numbers last month were followed by a strong PCE number, which sort of gave the green light to interest rates to continue moving up to 4.7%. This move up in rates seemed to act as the negative catalyst to start the April selloff in the equity markets, the one I have been talking about.

What I found interesting last week was that even though we got this disastrous duo of lower-than-expected growth and continued higher than expected inflation, this recipe for decline in stock prices seemed to have run its course before the numbers were released.

The implications: The Fed does not like the slowest GDP growth rate in almost two years and lower than forecasted. This number, combined with inflation numbers and employment numbers that are stronger than they would liked, seems to telegraph “higher-for-longer” as far as rates are concerned. At the same time the risk of an eventual recession started to heat back up. The puzzler was that instead of the market continuing its correction when the stagflation numbers hit, there seems to be a bit of change in the wind that has been at the back of inflation. This comes in the form of numerous indicators sort of changing:

  • The US Dollar has been getting stronger as the rates have been coming back up--this move has seemed to reach a ceiling here around 105.5-106 for the last week. This implies rates might be close to rolling over.
  • Gold has been on a tear and seems to be in need of a much-deserved rest after a 13% move up so far this year.
  • Major discretionary retail stocks seem to be telegraphing the economic slowdown before the GDP number was released, with problem reports from many of them.
  • The major index, S&P 500, seemed to have had enough of the decline as it reversed last week after 6 straight down days - a very uncommon progression.
  • The last was the Investor’s Intelligence Bull/Bear number which dropped to 2.1 from 3.9 with bullishness sliding to 46.2% from 56.5%. This now shows the lowest degree of optimism since early November (when the market turned up), the prior five occurrences of bullishness falling at 10% in a week’s period include: October 1987, November 1991, March 2008, January 2010, and February 2018. All of these ended up being pretty good times to enter the markets when psychology moved negative so fast.

So here is the picture of what the S&P 500 looked like coming into this week:

And if we were to look at the “growthier” NASDAQ Composite, the action is the same and even more pronounced:

So, this leaves me thinking, what if the Fed is sniffing that just maybe they don’t need to ease rates, but instead they slow down their pace of Quantitative Tightening by slowing the pace of bond buying and therefore keeping liquidity for the banking system. Just maybe this would be a sign that they are starting to see what they were hoping to see. Powell would be able to say, “Hey, we aren’t at our 2% inflation number, but we are seeing progress.” This would imply that the market is sort of fixing itself and that the Fed can sit back and wait to take action for longer. We will see this afternoon when Fed Chair Powell gives his testimony.

It is said that corporate earnings are the “mother’s milk” of a strong economy. The current earnings reports seem to infer that the economy seems to be quite healthy. Since economic prosperity at the corporate level tends to be the backbone of a strong economy, as long as earnings stay healthy, stock prices should be able to do so as well. We are currently about halfway through earnings season, and this is how things are looking:

80% of the reports have beaten estimates and beaten by a surprisingly strong 8.3%.

This week we are sort of at a flat spot in economic reports, but the Fed meets this afternoon and Powell might drop a few more breadcrumbs for the markets. April was negative, May could go either way, but June, if the presidential election cycle holds true this time, could be time for the next continued move higher into year-end. Big-Cap tech earnings seem to be continuing their advancement thanks to AI, so we will look to the industrial companies this week to see if they are showing nut-and-bolt earnings remaining strong.

All of these points brought me to my appreciation of the Peper and Salt comic in last week’s Wall Street Journal:

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