Get ready for a hawkish surprise; S&P 500 Rally Faces Test

Tuesday’s CPI inflation data may have thrown investors a curveball ahead of today’s Fed meeting. The S&P 500 initially rallied on the data as markets priced in a lower peak for the Federal Reserve’s key interest rate.




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Yet there are good reasons to doubt that Fed Chairman Jerome Powell will be swayed by the more tame readings for the consumer price index and core CPI inflation. In fact, Powell gave a speech Nov. 30 explaining why those are the wrong inflation rates for the Fed to consider.

There is no doubt that today the Fed will reduce its rate of hike, with a half point increase. This will raise the federal funds rate to a range of 4.25% to 4.5%.

Fed meeting to clarify rate hike prospects

But November’s CPI report, which showed the inflation rate falling to 7.1% from 7.7%, may have shifted expectations too much for the next Fed meeting and cycle high.

After the core CPI has risen just 0.2% since October, markets are pricing in a 62% probability that the Fed will hike just 25 basis points on Feb. 1. But it’s possible Powell will use his 2:30 p.m. press conference to suggest another half-point hike, barring unforeseen developments, such as job gains turning into job losses.

Along with the 2 p.m. ET policy statement, the Fed will also release quarterly economic projections, including the outlook for interest rates. At their September meeting, policymakers pointed to a peak rate of 4.6% in 2023. Markets now see the Fed’s key rate peaking at 4.9% in May, down from around 5.05 % before CPI report, according to CME Group’s FedWatch page.

Yet today’s Fed projections could show the federal funds rate slightly above 5% through the end of next year.

If the Fed’s guidance proves more aggressive than markets expect, it probably won’t hit the S&P 500 too badly in Wednesday’s stock market action. With inflation down, markets may remain in a good mood.

Yet Powell, as he did last month, is likely to argue for keeping interest rates higher for longer, shifting focus from the CPI to wage growth. This would likely keep a damper on the current rally.

The Fed’s new key inflation rate

The specific inflation rate that Powell says the Fed and Wall Street should focus on comes from the Commerce Department’s Monthly Personal Income and Spending Report, which tracks personal consumption expenditures, or PCE.

Powell’s new preferred inflation rate appears to be the most problematic for the S&P 500. The gauge takes into account commodity inflation, which is rapidly declining. It also excludes housing inflation, which looks set to ease in 2023 as government data catches up with stalled market rental growth.

That leaves only basic services other than housing, such as health care, education, hospitality, and haircuts. Because price changes for such services are closely tied to wage growth, they provide the best signal of where core inflation is headed, Powell said.

The Fed’s new key inflation rate isn’t great for the S&P 500 because it puts stress on the strongest part of the economy: the tight job market. Until the job market collapses, wage growth is likely to remain stubbornly high and the Fed could hike its key interest rate higher and for longer than markets expect.

The CPI report showed that prices for basic services excluding hospitalizations were unchanged in November from the previous month. But the similar PCE index will not be so tame. This is partly because the two indices measure health services inflation in very different ways, with the PCE measure more reflecting wage pressures. The CPI medical care services index fell 0.7% in November, the largest monthly drop on record.

S&P 500 near key level

S&P 500 futures were up 0.4% in early Wednesday’s stock market action, following Tuesday’s 0.7% gain. The S&P 500 was up nearly 3% to its morning highs after the docile CPI. But investors probably didn’t want to be blindsided by an aggressive Fed meeting.

The Dow Jones Industrial Average was also up 0.4%, while the Nasdaq Composite was up 0.1%.

The S&P 500 broke through its 200-day intraday line on Tuesday, before closing below the key technical level. The last attempts to rally until April stopped at the 200-day moving average.

All major indices ran into resistance at their December 1st highs on Tuesday.

Through Tuesday’s close, the S&P 500 was up 10% from its October 12 bear market closing low. However, the S&P 500 remains 18% below its January 3 all-time high. The Dow Jones is up 16.5% since it bottomed, leaving it just 9% short of its all-time high. The Nasdaq rebounded 6.6% but remains 31.5% below its peak.

Be sure to read IBD’s The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.

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