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S&P 500 Reversal as Fed Manages to Lift Rate Expectations Even Further

S&P 500 Reversal as Fed Manages to Lift Rate Expectations Even Further

John Kicklighter,
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S&P 500, VIX, Fed, Dollar, AUDUSD and USDJPY Talking Points

  • The Trade Perspective: USDJPY Bearish Below 121; AUDUSD Break from 0.7550 to 0.7450 Range; Crude Oil Bullish Above $100
  • VIX posted its biggest swell in a month after tagging a three-month low Monday as headlines around Russian sanctions and inflation warnings expanded
  • US rate forecasts have been pushed even higher as a potential hold-out dove voices support for an accelerated quantitative tightening
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A Necessary Reversal Perhaps, But Not a Necessary Trend

The debate over whether the US indices and risk assets at large have returned to the larger post-pandemic bull trend or we are simply passing through a bear market correction rages on. You may not actively indulge the in the deliberation, but there are few greater medium- to long-term questions that carry more weight for market participants. This past session, there was a very notable check lower for benchmark speculative assets nudged by the escalation of sanctions on Russia (which will inevitably have blowback for the rest of the world) and an unexpected further escalation of the already-heady monetary policy outlook. Where the rubber meets the road, the S&P 500’s 0.8 percent rally on Monday was more than offset by this past session’s -1.3 percent slide. The market has yet to clear last week’s range and volume on the SPDR ETF (one of the most heavily traded derivatives in the world) doesn’t immediately signal a shift in conviction with the change in direction. Then again, the swoon was broad and there was a notable intensity for riskier measures which shows through in the Nasdaq 100 to Dow ratio (growth to value).

Chart of S&P 500 with 20 and 200-Day SMAs, Net Speculative Futures Positioning (Daily)

Chart Created on Tradingview Platform

Another realistic measure to the state of the market’s speculative balance is the VIX volatility index. As of Monday, the ‘fear’ gauge dropped to its lowest level since January 12th, below the 200-day simple moving average. In the kind of quiet chop higher we have been used to in previous years, such a bearing wouldn’t look out of place; but when we factor in inescapable risks like the fallout from the Russia-Ukraine war and a global monetary policy withdrawal, such complacency seems very improbable. Therefore, this past session’s biggest VIX jump in a month – following a month of incredible deflation – to move us back to the 200-day SMA isn’t exactly an extreme move with vast implications. I still believe these markets are underpricing the risks in the system, but I will be looking for the underlying (eg the S&P 500) to signal sentiment’s next move rather than this lagging and speculatively-engaged derivative.

Chart of VIX Volatility Index with 20 and 200-Day SMAs (Daily)

Chart Created on Tradingview Platform

The Top Themes That Add to the Fire and One That Cools the Flames

There remain three major themes that I’m keeping close track of for the global financial markets: Russia; monetary policy and growth forecasts. There was a notable pressure increase – to the detriment of the market’s buoyancy – from the first two, but the outlook for economic potential received an unexpected boost Tuesday from data and a timely market benchmark. From the US docket, the ISM service sector activity report rose 1.8 points to halt a multi-month tumble from record highs. Subcomponents for orders, employment and of course inflation all rose as well. That is a relief valve for the world’s largest economy, but the more closely watched improvement this past session was likely the ‘reversion’ of the US 10-year to 2-year Treasury yield spread. The spread was only inverted for two trading days, but that doesn’t ensure the escape from an economic stall. Meanwhile, Russian headlines took a notable turn for the worst as accusations of war crimes grew and calls for intensified sanctions built. Reports that the US was blocking Russia’s access to dollars to fulfill a bond payment (approximately $551 million) seriously raises the risk of a default – and fallout for Western exposure. Watch the headlines as there are supposedly fresh sanctions coming from the G7 later today.

Chart of Major Macroeconomic Events

Calendar Created by John Kicklighter

While Russian headlines are must watch and growth forecasts are likely to remain highly volatile moving forward, I believe monetary policy is the more loaded fundamental theme to keep tabs on. The Reserve Bank of Australia (RBA) may have held rates Tuesday, but it seemed to clear the path for rate hikes in the immediate future. That is another major authority that is positioned for or acting on monetary policy. The list of central banks among the ‘majors’ that is already acting on their benchmarks is growing, but it will take some time before their tightening materially impacts liquidity or significantly bolsters the rate of return to be had in the market. However, it is not clear how ‘quantitative tightening’ (the reduction in bloated stimulus programs) will impact both fronts. I believe it is a more abstract risk and has been poorly accounted for by markets. In turn, it has the potential of generating greater market adjustment (aka volatility or risk aversion).

Chart of Central Bank Monetary Policy Stance with Rate Forecasts

Chart Created by John Kicklighter

The Case of the US Dollar

There was a remarkable volatility in the FX market this past session. It was hard to miss a few of the more prominent moves amongst the majors like EURUSD’s fourth consecutive daily slide through 1.0900 (with key resistance at 1.08), USDJPY’s pressure on 124 despite BOJ Governor Kuroda’s not-so-subtle warning about the exchange rate’s height and AUDUSD’s overdue break. I was highlight that latter currency cross’s extremely narrow 8-day range through Friday – the smallest since December 2019. A break was inevitable, but follow through was not. An RBA rate decision would help tease market conviction. We ended up with the 0.7550 break thanks to the central bank clearing the path towards rate hikes in the coming meetings (the Aussie 2-year yield crossed above the 2.00 percent threshold). However, that relative strength was disrupted on AUDUSD owing to an upgrade Fed rate forecast.

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Chart of AUDUSD with 20-Day SMA (Daily)

Chart Created on Tradingview Platform

Generally, I think the hawkish Fed outlook is fairly extreme. That is not to say that I don’t believe the central bank will act on its warnings of an expedited tightening of the benchmark rate and reduction in its balance sheet. Rather, it seems like a lot of that aggression is accounted for in the markets from Fed Funds futures to Treasury yields to even the Greenback. Nevertheless, the outlook seemed to firm even further with the DXY Dollar Index managing to push its recent multi-month range to trade at 21-month highs. On the rate forecast front, implied hikes for the next three meetings managed to rachet up expectations for serial 50bp hikes even further. I didn’t think that probable, but one of the potential hold outs among the FOMC doves, Vice Chair Brainard, put to rest any notion of moderating voices on the board when she supported an aggressive QT support. I still think it is difficult to push the outlook even higher; but it isn’t impossible. Watch for further Fed speak ahead, but the FOMC meeting minutes are far more primed for official market swaying.

Chart of DXY Dollar Index with 100-Day SMA Overlaid with Implied May Rate Hike (Monthly)

Chart Created on Tradingview Platform

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