S&P 500 Rally Could Ease Monetary Conditions to Undermine Fed’s Fight

S&P 500 STRATEGY: SELL THE RALLY

• The S&P 500 has made solid gains post FOMC and might continue near term
• The market has interpreted a pivot from the Fed and it remains to be seen if this is true
• The fight on inflation appears to have same way to go given where the level of PPI is

S&P COULD RUN RIOT IN THE ABSENCE FEDERAL RESERVE ACTION

The Federal Reserve’s openly stated goal of tightening monetary conditions might be hindered by market forces and a longer than usual interlude between meetings.

In the aftermath of last week’s Federal Open Market Committee (FOMC) meeting, the S&P 500 has rallied over 5%. At the same time, corporate bond spreads have narrowed. This is an easing of monetary conditions. The opposite of what the Fed is trying to achieve.

The time between FOMC meetings is usually around 6-weeks. The next FOMC meeting doesn’t start until 20th September, which is an 8-week gap, the longest in the calendar.

An extended break between meetings means that Fed action is some way off and if policy goals are not being met, there is little they can do other than jawbone. Of course, the Fed could call an extraordinary meeting if conditions warrant it, but that would appear unlikely unless a severe event were to occur.

The market perceives that the Fed has pivoted away from an aggressive tightening regime. Fed Chair Powell even commented in unscripted remarks after the FOMC meeting that the current Fed funds rate is at neutral.

Over the weekend, former US Treasury Secretary Larry Summers ridiculed the prospect that the Fed funds rate of 2.5% is at neutral when inflation is 9.1%. In any case, it has been noted before that the rate may need to be significantly above neutral to rein in inflation.

The US has never lowered inflation by 2% or more without a recession. Last weeks GDP number revealed an annualized contraction of -0.9% for Q2 2022.

A problem for the outlook on US CPI that hasn’t gained a lot of attention is the rise in PPI. After decelerating through April and May, the latest data illustrates cost pressures for companies have re-accelerated, with final demand PPI printing at 11.3% year-on-year to the end of June.

Chart Created in TradingView

With PPI remaining stubbornly high, companies can either pass on their higher costs to consumers or they face margin compression.

The former will add to CPI, which will put further pressure on the Fed to tighten more aggressively. The latter will see earnings slide and if P/Es are to remain constant, the price must fall.

In any case, if a company passes on increased costs or absorbs them, both scenarios present challenges for corporates going forward. While backward looking earnings results so far this season have mostly been good, the market appears to be looking in the mirror rather than the road in front of them.

The reason for the current rally can easily be explained by a lot of cash that had been sitting on the sidelines and is now being deployed. With that in mind, the S&P 500 could add to recent gains, particularly in the absence of any action from the Fed until late September.

The exhaustion of the rally might be a way off, but once it turns, the opportunity with a sound fundamental basis could be from the short side heading into the end of the year.

S&P 500 TECHNICAL ANALYSIS

Levels to watch on the topside could be the previous highs of 4202 and 4303 and some Fibonacci retracement levels of the move from the January peak to the June low.

The 50% Fib level of that move is at 4225 and the 61.8% retracement is at 4361. A descending trend is currently just below the latter.

S&P 500 daily chart created withTradingView

S&P TRADING RESOURCES

— Written by Daniel McCarthy, Strategist for DailyFX.com

To contact Daniel, use the comments section below or @DanMcCathyFX on Twitter