Fed Funds Forecast and Stocks in the Twilight Zone

Investors have been looking past the 40-year high inflation rates (CPI) for months, having concluded the Fed is on a Bullish glide path toward stable consumer prices and near the end of their rate hiking cycle. The super charged jobs data over the past 2 months has reignited concern over sticky inflation and a higher cost of credit than is currently reflected in stock valuations. Today’s report of more than 310,000 jobs created in February proves that the whopping 500,000+ payroll increase was not a gross aberration, and that wage and services inflation remain strong. After a surprisingly robust spike to the upside last week, stocks have reversed lower to new 6-week lows this week. Small and midcap indices have now erased all of their gains for the year. Stock values are back into the twilight zone just below full steam ahead levels reflecting a sharp CPI decline and just above the investor capitulation level that corresponds to higher-than-expected interest rates and spending. Prior to the uber ebullient employment report today, Fed Chair Powell had hinted that a surprise 50 basis point Fed Funds rate hike was possible this month. Despite the shock of a $175 Billion tech sector bank (SVB) going bankrupt today due to rising rates, the persistently tight labor market increases the odds of an outsized March rate hike. The major stock indices plunged 5 to 8% this week in acknowledgement of rate hike fears, in line with the timeline of our Seasonal forecast.

The final straw to determine the terminal rate forecast for Fed Funds in 2023 and how fast we get there will be the Headline CPI report on March 14th. A monthly reading of 0.2% or lower should ease investor fears and trigger the start of our forecasted rally into mid-April toward SP 500 Index 4200 – 4300. However, a hot number of 0.4% or higher increases the odds greatly that a 50-point rate hike will be priced into the March and May meetings, which could send stocks back to test their Bear market lows. A number between 0.2 and 0.4% is more of a coin flip as to the equity market reaction short term. The good future news for the Fed that they don’t want to squander, is that the next 5 months of Year over Year (YoY) will be removing historically high monthly CPI numbers. This will make it much easier to bring down YoY inflation rapidly if the monthly data returns to normal just under 0.2% rates going forward.

The bad news is that the markets may finally start pricing in the Fed interest rate risk they have been conveying to investors if CPI is above expectations next week. The recent 8 to 10% correction since the February top has partially discounted higher than expected interest rates and the cost of capital. Should the CPI report come in hot (>0.4% monthly) and the Fed hike to a 5% rate, stocks should still bottom out short term in March. Readers know that our outlook advised raising cash and hedging for a correction from February 15th to mid-March (no later than the 23rd). As this downtrend concludes, we will be looking to add stocks over the next 2 weeks. The primary target for this correction has been 8 to 12% with ideal support in the mid to upper 3700’s basis the SP 500. While cyber security and military defense (including Boeing) remain sectors with deep backlogs, large cap stocks should also do well “during the up phases” of this long-term trading range stock market in 2023.




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