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S&P 500 Enters Bear Market Ahead of FOMC. How Will Stocks React to the Fed?

S&P 500 Enters Bear Market Ahead of FOMC. How Will Stocks React to the Fed?

Diego Colman, Market Analyst

US STOCKS OUTLOOK:

  • S&P 500 plunges 3.88% and closes in bear market territory for the first time since 2020
  • The Nasdaq 100 plummets 4.6%, setting a new 2022 low
  • Equity market weakness could continue if the Fed adopts a more hawkish stance at its June meeting this week in an effort to crush inflationary pressures in the economy

Most Read: S&P 500, Nasdaq 100 Drive in to 'Bear Market' Territory Ahead of the Fed

U.S. stocks plummeted on Monday, weighed down by soaring U.S. Treasury yields, on expectations that the Federal Reserve will come out swinging and take a tougher stance on inflation at its gathering this week, endorsing a significantly steeper path of interest rate increases.

When it was all said and done, the S&P 500 sank 3.88% to 3,749, setting a new 2022 low and closing in bear market territory for the first time since the 2020. The Nasdaq 100, for its part, bore the brunt of the sell-off, plunging 4.60% to 11,288, also a fresh low for the year.

The Fed will start tomorrow its June monetary policy meeting and announce its decision on Wednesday afternoon. Most Wall Street financial institutions expect the bank to increase borrowing costs by half a percentage point to 1.00-1.50%, but a few desks are now calling for a more forceful response following the latest developments on the inflation front.

For context, the May CPI rose 1.0% on a seasonally adjusted basis, pushing the annual rate to 8.6%, the hottest reading since 1981, a sign that inflationary pressures did not peak during the first quarter, as economists had widely anticipated. Energy was the largest contributor to the monthly gain after prices at the pump surged 4.1%. This trend is getting worse in June, with average gasoline prices up more than 10% m-o-m, suggesting that headline CPI could top 9% in the summer and hit a new cycle’s high.

Raging consumer prices could prompt the FOMC to continue withdrawing accommodation forcefully during the second half of 2022 to bring the policy stance to neutral or even restrictive terrain expeditiously. But could the central bank surprise investors with a 75 bp hike this week? Personally, I think the Fed will stick to the script and lift the cost of money by 50 bp so as not to create unnecessary market chaos/volatility or to signal desperation. True, Chairman Jerome Powell has pledged to be nimble, but he has also indicated that “monetary policy works through expectations” and that the committee will "strive to avoid adding uncertainty" given the extraordinarily challenging environment.

However, the Fed could embrace a much more aggressive tightening bias than currently priced in. With inflationary pressures broadening dramatically, policymakers will have to get tougher in their fight to restore price stability and to regain control of the narrative. Though financial conditions have tightened significantly since the start of normalization process, they haven’t tightened enough to strangle excess demand in a meaningful way. Consumption needs to slow to a crawl to accomplish this goal. To get there, the Fed will have to allow unemployment to rise in a non-trivial manner and undermine the wealth effect via more equity market weakness in the coming months, increasing the probability of a hard landing. Needless to say, this could result in more pain for stocks during the second half of the year.

In this context, Fed officials will likely flag, through the dot-plot, that they intend to front-load tightening in 50 bp increments through the end of the year or, under a more hawkish scheme, signal that they will step up the size of rate hikes at coming meetings, bringing into play jumbo 75 bp adjustments, something we haven’t seen in 28 years. The latter scenario could spark the next leg higher in U.S. Treasury yields, triggering another brutal sell-off on Wall Street. For these reasons, the S&P 500 and the Nasdaq 100 will remain firmly biased to the downside in the coming days.

S&P 500 TECHNICAL ANALYSIS

After Monday’s massive sell-off, the S&P 500 set a new 2022 low and officially closed in bear-market territory, reinforcing its near-term negative outlook. The index, however, wasn’t able to break below channel support, stretching from 3,700 to 3,735. If this area holds in the coming days, we could see a modest rebound, but gains will likely be moderate amid depressed sentiment and reduced appetite for risk assets heading into the FOMC decision on Wednesday.

On the flip side, if the bears maintain control of the market and push the index below 3,735/3,700, selling pressure could accelerate, exposing the 3,500 zone, a key floor created by the 50% Fibonacci retracement of the 2020/2022 rally.

S&P 500 TECHNICAL ANALYSIS

S&P 500 technical chart

S&P 500 Technical Chart Prepared Using TradingView

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