Support for a splash of cold water for the Dow Jones Rally

The setup for the conclusion of tomorrow’s Federal Reserve meeting looks promising for a continuation of the recent Dow Jones Industrial Average rally. A second straight rate hike of 75 basis points is already baked in, so stock market reaction to Wednesday’s monetary policy statements should depend on what Fed chief Jerome Powell signals about the September meeting, nearly two months away.

X

Inflation finally seems to be past its peak, and the price of gas and other commodities is falling. Meanwhile, a string of unexpectedly weak economic data has begun to pile up. Thursday morning’s GDP release could feature back-to-back quarters of negative growth, if the White House backlash is any indication. Against that backdrop, a moderation in the Fed’s rate hike pace to half a point in September seems logical.

Still, market prices still indicate roughly 50% odds of a third straight 75 basis point hike on Sept. 21, according to CME Group’s FedWatch site. Fed guidance pointing to a continued hefty half-point move will make for easier-than-expected policy and should be enough to keep investors rallying.

So what could — and likely will — go wrong for those betting on a sustained stock market rally with an assist from this week’s Fed meeting?

At the moment, inflation remains too high and unemployment too low for the Fed to worry about cushioning the economy’s landing. In addition, Fed officials are always assessing how markets might react to changes in monetary policy. At this point, they would likely see a Dow Jones rally as premature, as it would counter their attempts to cool demand via tighter economic conditions. So they can be careful not to give investors reason for optimism in the short term.

Unexpected Federal Reserve Pivot?

Wall Street strategists increasingly expect the Federal Reserve to swing to a slower pace of rate hikes. As slow growth turns to a brush with recession, the Fed is seen to halt interest rate hikes. By spring 2023, an interest rate cut may be up for consideration. The increase in the dollar vs. foreign exchange, which has already contributed to tighter economic conditions, is a central part of their task. The strong dollar could lower the Fed’s interest rate ceiling in this cycle.

While the bullish pivot scenario makes some sense, the Fed could surprise with a different kind of pivot. Recently, Powell has played up the importance of top-line inflation, including volatile food and energy prices, as being most relevant to consumers. That makes sense, because if their gas and grocery bills go up, workers may be more determined to push for bigger pay raises. The large wage increases can, in turn, force companies to pass on labor inflation via price increases to their customers.

But now that the rise in gas prices and, to some extent, food prices are slowing, Powell may shift his focus to a part of inflation that has yet to show progress. The June CPI report showed prices for non-energy services – categories such as rent, medical services and transport that 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 seen as more sticky, as it is less subject to supply fluctuations and more linked to wage growth. Powell has said the Fed needs to see both inflation and disinflationary pressures fall convincingly. Persistent service inflation shows that there is much more work to be done.

Recession debt

Presumably, the Federal Reserve will get a look at Thursday’s GDP report ahead of Wednesday’s policy decisions. Wouldn’t back-to-back quarters of negative GDP growth put pressure on the Fed to slow its rate hike trajectory?

Not necessarily. The Fed can make a decent argument that real growth is negative just because inflation is so high. Walmart‘s ( WMT ) earnings warning on Monday hinted at something similar, and the company said comparable sales growth would be higher than expected.

Getting inflation down is the key to turning nominal spending increases into real ones, Powell might say.

Even the Fed’s unlikely soft-landing estimate issued in June envisions the unemployment rate creeping up to 4.1%. It now stands at 3.6%, near a half-century low. The Fed sees higher unemployment as part of the process of dealing with inflation, rather than something to avoid.

There may also be talk of whether the Fed’s key interest rate is really in neutral territory. It is set to rise to a range of 2.25%-2.5%. Politicians believe that the long-term neutral interest rate is around 2.4 per cent. This assumes that inflation returns to the target. As long as the Fed’s benchmark interest rate is negative in real terms—below the rate of inflation—it arguably remains accommodative.

Fed Cred

A key to a bullish pivot is the notion that the Fed has regained credibility in the fight against inflation with back-to-back increases of 75 basis points. If the Fed doesn’t need to be as concerned about expectations of higher inflation becoming entrenched, policymakers should feel some flexibility to hike at a more moderate pace, adjusting as needed.

Still, it’s probably too early for the Fed to let its guard down even a little. The biggest burst of inflation since the 1980s involves so many wild cards beyond the Fed’s control. That includes everything from Russia’s invasion of Ukraine to pandemic-related shutdowns. Politicians will not take for granted that their fortunes have finally turned.

In addition, Powell has noted that the forces of disinflation in recent 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 on Monday night. However, the Dow is still up 6.3% from its June 17 low. That reduced the loss to just 13.7% from the January 4 closing high. The S&P, despite Tuesday’s 1.2% drop, has clawed back 6.9% of its losses and is now 18.25% off its peak. Although the Nasdaq fell 1.9% on the session, it has had an 8.6% pullback, but is still 28% below its peak.

The rally has come as the 10-year Treasury yield, after rising near 3.5%, has fallen back. It is now near 2.8% as investors expect a further decline amid Federal Reserve tightening, which eventually leads to interest rate cuts.

At the end of 2018, it only took a 20% market decline for the Fed to end its program of rate hikes and balance sheet tightening. In autumn 2019, the Fed cut interest rates and bought more assets. But inflation was running below target at the time, not at a generational high.

The Dow Jones and other major indexes have broken above their 50-day lines for the first time since April. It reflects optimism about a Fed central bank, but the uptrends are currently under pressure. Be sure to read IBD’s daily The Big Picture column after each trading day to stay on top of the market trend and what it means for your trading decisions.

Follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.

YOU MAY ALSO LIKE:

The Fed recession: Tax data is flashing a big red flag

Why this IBD tool simplifies the search for top stocks

Get the next big winning stock with MarketSmith

Do you want to make quick profits and avoid big losses? Try SwingTrader

Market slips with Fed rate hike due; Hot Stock Pops Late