Get ready for a splash of cold water for the Dow Jones Rally

The setup for tomorrow’s Federal Reserve meeting looks promising for a continuation of the latest rally in the Dow Jones Industrial Average. A second consecutive rate hike of 75 basis points is already on the cards, so the stock market’s reaction to Wednesday’s monetary policy statements should depend on what Fed Chief Jerome Powell signals about the meeting. of September, in almost two months.
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Inflation finally seems to have passed the peak, with the fall in the price of gasoline and other raw materials. Meanwhile, a series of surprisingly weak economic data began to accumulate. Thursday morning’s GDP release could show back-to-back quarters of negative growth, if the White House’s recession denials are any clue. Against this backdrop, moderating the pace of Fed rate hikes to half a point in September seems logical.
Still, market prices still point to about a 50% chance of a third straight 75 basis point hike on Sept. 21, according to the CME Group’s FedWatch page. Indications from the Fed of a still large half-point move would amount to easier-than-expected policy and should be enough to keep investors’ rally caps going.
So what could – and probably – go wrong for those betting on a sustained stock market rebound with some help from this week’s Fed meeting?
Right now, inflation is still too high and unemployment too low for the Fed to care about cushioning the economy’s landing. Additionally, Fed officials always consider how markets may react to changes in monetary policy. At this point, they would likely view a Dow Jones rally as premature, as it would run counter to their efforts to cool demand via tighter financial conditions. They can therefore be careful not to give investors grounds for short-term optimism.
Unexpected pivot from the Federal Reserve?
Wall Street strategists increasingly expect the Federal Reserve to move toward a slower pace of rate hikes. As slow growth turns into a recession, we see the Fed suspending rate hikes. By spring 2023, a rate cut could be considered. The rally of the dollar against foreign currencies, which has already contributed to the tightening of financial conditions, is a key element of their thesis. The strong dollar could lower the Fed’s interest rate cap during this cycle.
While the bullish pivot scenario makes some sense, the Fed might surprise with a different type of pivot. Recently, Powell has highlighted the importance of turnover inflation, including food and energy price volatility, as what is most relevant to consumers. That makes sense, because if their gas and grocery bills go up, workers might be more determined to demand bigger pay raises. These large wage increases, in turn, may force companies to pass on labor inflation via price increases to their customers.
But now that the spike in gasoline prices and, to some extent, food prices is easing, Powell could focus on a component of inflation that has yet to rise. The June CPI report showed prices for non-energy services – categories such as rent, medical services and transport which account for 57% of household budgets – rose 5.5% from a year ago, the highest rate of inflation since 1991.
This type of inflation is considered more rigid, as it is less subject to fluctuations in supply and more linked to wage growth. Powell said the Fed needs to see both inflation and inflationary pressures come down convincingly. The persistent inflation of services shows that there is still a lot to do.
Recession blame
Presumably, the Federal Reserve will review Thursday’s GDP report ahead of Wednesday’s policy decisions. Wouldn’t consecutive quarters of negative GDP growth put pressure on the Fed to slow its rate hike path?
Not necessarily. The Fed can make a decent argument that real growth is negative only because inflation is so high. walmartMonday’s (WMT) earnings warning suggested something similar, with the company saying same-store sales growth would be higher than expected.
Reducing inflation is the key to turning nominal spending increases into real increases, Powell might say.
Even the Fed’s unlikely soft-landing projections released in June forecast unemployment rising to 4.1%. It now stands at 3.6%, nearly a half-century low. The Fed sees rising unemployment as part of the process of fighting inflation, rather than something to be avoided.
One can also discuss whether the Fed’s key rate is really in neutral territory. It should reach a range of 2.25% to 2.5%. Policymakers estimate the long-term neutral interest rate to be around 2.4%. This assumes that inflation returns to its target. As long as the Fed’s benchmark rate is negative in real terms, ie below the rate of inflation, it is likely to remain accommodative.
Fed Credit
One of the keys to a bullish pivot is the idea that the Fed has regained its inflation-fighting credibility with back-to-back 75 basis point hikes. If the Fed doesn’t have to worry so much about expectations of high inflation taking root, policymakers should feel some flexibility to rise at a more moderate pace, adjusting as needed.
Still, it’s probably too soon for the Fed to let its guard down a bit. The biggest inflation spike since the 1980s involves so many wild cards beyond the Fed’s control. This includes everything from Russia’s invasion of Ukraine to pandemic-related shutdowns. Policy makers will not take it for granted that their luck has finally run out.
Moreover, Powell noted that the disinflationary forces of the past decades have pushed in the other direction. Most notable are workforce demographics and globalization.
Dow Jones Setup
The Dow Jones fell 0.7% on Tuesday after Walmart’s warning Monday night. However, the Dow Jones still climbed 6.3% from its June 17 closing low. That reduced its loss to just 13.7% from its all-time closing high on Jan. 4. The S&P, despite falling 1.2% on Tuesday, has retraced 6.9% of its losses and is now 18.25% from its closing high. The Nasdaq, although slipping 1.9% on the session, enjoyed an 8.6% rebound but remains 28% below its peak.
The rally came as the 10-year Treasury yield, after climbing to nearly 3.5%, retreated. It is now close to 2.8% as investors anticipate further slowing amid Federal Reserve tightening, which will eventually lead to rate cuts.
At the end of 2018, all it took was a 20% drop in the market for the Fed to end its program of rate hikes and balance sheet tightening. In the fall of 2019, the Fed was cutting rates and buying more assets. But inflation was below target at the time, not at a generationally high level.
The Dow Jones and other major indices broke above their 50-day lines for the first time since April. This reflects optimism about a pivot from the Fed, but uptrends are currently under pressure. Be sure to read IBD’s The Big Picture daily column after each trading day to stay up to date with the market trend and what it means for your trading decisions.
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
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