Is the Stock Market Running the Fed?

Opportunity always exists when the crowd thinks it knows an unknowable future

The Ivory Hill RiskSIGNAL is firmly red, and we are still sitting around 60% cash levels.


The markets have gotten so bad that it might actually be a positive in the short term. Confidence has dropped to the lowest levels that I have seen in my career.


The NASDAQ is down -31.61% YTD and the S&P 500 is down -22.12% YTD.


The latest leg lower in stocks has seen the S&P 500 quickly approach the downside target of the bearish head-and-shoulders pattern that developed over the last few quarters. The S&P 500 has fallen 10% in just the last five sessions, which suggests the market is approaching oversold levels. However, there have been no signs of capitulation just yet and momentum is still decidedly bearish.


I want to be crystal clear, our downside target is based on fundamentals. During periods of high volatility fundamentals get tossed out the window.



The 10s-2s yield curve spread took a dive again overnight after Goldman Sachs and JP Morgan changed their forecasts to reflect a 75 basis point hike which is in line with market expectations. If the yield curve inverts for a second time this will spark more selling.



The markets have been taken back by Treasury Secretary, Janet Yellen's, admission.


“I think I was wrong then about the path that inflation would take,”
"As I mentioned, there have been unanticipated and large shocks to the economy that have boosted energy and food prices and supply bottlenecks that have affected our economy badly that at the time I didn’t fully understand”.

I appreciate her candor but anyone with a basic knowledge of monetary policy could see that inflation was going to be an issue going back to 2020. The market doesn't believe Yellen's latest statement that the US will likely avoid a recession. In other words, the market is skeptical of the narratives coming from the Federal Reserve and the US Treasury.



The Reuters/University of Michigan Consumer Sentiment Index dropped 8.2 points in the preliminary June survey to 50.2, a record low, and far below the consensus of 59.0. It was the fifth decline in the past six months, as the sticker shock of higher gasoline and food prices continue to weigh on consumers. The assessment of current conditions dropped to its lowest level since May 1975, while consumer expectations were the worst since May 1980.


Target Corporation's recent profit and inventory warning, the second downgrade in the past several weeks, is likely not a one-off issue. We’ve been hearing about weakness from both the consumer and retail sectors and this might be the best evidence yet that a major downturn is inevitable. The essence of the announcement is that Target is going to start offering deep discounts to clear out excess inventories to make room for things, like groceries and back to school supplies. Here is the real interpretation. Retail consumers are spending less as their COVID savings dries up and high food and energy prices are eating into their discretionary budgets.


Target overestimated consumer demand, possibly by a lot, and is now in the position of fixing the problem. We’ve been hearing for a while that recession risk isn’t actually that high because unemployment is still low and the consumer is still strong. Target's announcement may just be the tip of the iceberg in destroying that argument.



It's difficult to believe that this problem isn't affecting consumers everywhere right now. Retail earnings were already poor last quarter, and now one of the biggest retailers has lowered its projections even further. It won't be long until we hear a similar narrative from Walmart, Costco, or other retailers in need of price cuts to move inventory that has been lying on the shelf for too long.


This isn't likely to be limited to the retail sector. What happens to the labor market when a company's operating margin expectations are sliced in half, forcing it to cancel orders and drop prices in order to clear inventory? It begins by cutting expenditures elsewhere, with employee compensation being one of the most significant. Don't be surprised if you start hearing about layoffs as the downturn intensifies. The Fed will switch to a more dovish stance in an effort to avoid a recession if the labor market cools and consumer spending slows, but by that time it will probably be too late.


One of the worst parts about a recession is consumers are starting to rack up credit card debt for basic necessities. This is typical consumer behavior at this point because they think inflation will cool off and/or wages will rise.


FOMC PREVIEW


The Fed has been so slow in dealing with inflation the market is now practically begging it to raise by at least 75 basis points tomorrow.


Friday’s CPI report had a substantial influence on expected Fed rate hikes, as the year-end fed funds forecast rose to 3.125% (so a range between 3.00%-3.25%), while the February fed funds rate included an additional 25-bps hike, so 3.375%. Both of those numbers are substantially higher than estimates from a few weeks ago and reflect an additional 75 bps of hiking compared to March expectations.


We are now past the point of trying to determine which rate hikes will be 50 bps, which will be 25 bps, etc. Rates are going up in the next few months. Whether it comes in 50/75/25 bps isn’t important anymore.



What is important is 1) Where Fed officials see fed funds ending in 2022 and, more importantly, where the Fed sees the rate hike cycle ending—because that will give us insight into just how restrictive policy will be going forward.


What’s Expected: Median Year-End Fed Funds = 3.125%.

  • Terminal Fed Funds Rate = 3.375%.

  • Likely Market Reaction: A Mild Relief Rally Given The Declines of the Past Few Days.


Hawkish If: Median Year-End Fed Funds > 3.125%.

  • Terminal Fed Funds Rate > 3.375%.

  • Likely Market Reaction: In Some Ways the Market Already Priced This In On Monday.


Dovish If: Median Year-End Fed Funds < 3.125%.

  • Terminal Fed Funds Rate < 3.375%.

  • Likely Market Reaction: A Relief Rally (perhaps a big one).


Wildcard to Watch: 75 Basis Points


Yesterday, the Wall Street Journal released an article signaling the Fed might raise rates by 75 bps. If you have been paying attention, last month, Powell told the markets he was taking the 75 bps hike off the table.


I think this is less of a wildcard than most think. For the majority of this year, Powell and Company followed the market's rate hike expectations almost perfectly so this could be Powell's way of making a statement and regaining control of the situation.


I think the Fed more than likely leaked this news to the WSJ to test the market or to rip the Band-Aid off before the press conference tomorrow. Only time will tell.



If the Fed does hike 75 bps that will cause a sharp market decline.


But while that will add more short-term downward pressure, the most important issue with the Fed will remain 1) Where do we end the year on fed funds and 2) At what fed funds rate does the Fed stop hiking.


The silver lining of the recent selloff is the market has priced in more rate hikes than it previously expected, so it is partially priced in going into tomorrow. At the same time, it’s not clear the market is hawkish enough and reaching “peak hawkishness” for the Fed is a prerequisite for this market finding a bottom. So, if the Fed is not as aggressive as feared, then stocks should be able to bounce (although it’ll take more than just one Fed meeting to reach peak hawkishness as we still need a clear peak in inflation).


We will continue to sit on our cash and "hide" in our defensive equity positions until our signals flip green. Patience is key.


Feel free to use me as a sounding board.


Kurt S. Altrichter, CRPS®

Fiduciary Advisor | President

Direct: 952.828.5336

Email: kurt@ivoryhill.com

—Written 6.14.2022.