What a difference a day can make. The Fed is back to making speeches that throw the market into a tailwind. Channeling his inner Volcker on Friday, Powell said, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.”
Powell continued, “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.” That means the market is wrong in thinking that interest rate hikes are going to slow down anytime soon. And it may mean more 75-point hikes in the near future.
This also means the chances of a recession are rising because forcing a recession seems to be the only solution to solving inflation, whether it be in the early ‘80s or today. With the desire to bring inflation down to 2%, and core Personal Consumption and Expenditures (PCE) near 5%, the Fed has no other choice but to keep raising rates.
With the incremental adjustments the Fed is making, we can start putting a timeline together for different scenarios.
Keep reading to see where we could go by the end of the year.
Let’s look at PCE as a way of gauging inflation. The historical average is 3.22%, but the average monthly move is about 0.2%. That means going from 4.6% in July to 2% is going to take over 12 months. Even if we can get a dramatic decrease of 0.5% a month, it’s still going to take 5 months to get inflation to the Fed’s goal.
How high will the Fed have to raise rates? The Fed wanted interest rates to be 3.25% and 3.5% by the end of the year and next year to raise rates to between 3.75% and 4%. However, if the economy doesn’t cooperate quicker, the Fed will be forced to raise interest rates higher – possibly up to 5%. I believe they will accelerate raising interest rates until they get them above the PCE number and then start thinking about lowering interest rates if the PCE number continues to fall.
One scenario is that the market is going to return to heightened volatility like what we saw in June. Here’s a chart of the volatility index, the VIX. We could see volatility continue to rise over the next two months into the lower 30s. The market typically acts inversely to the VIX. We could see the average true range of each trading day could climb, as it did in June. That means the potential to return to big daily swings in the market.
If you believe the market hates uncertainty and will be volatile until the end of the midterms, you can trade the increase in volatility by trading the VIXY, which is an ETF of the VIX. Look for VIXY to go from $14.77 to just over $16 before hitting resistance.
Another scenario is for the market to fall until we hit a 50% retracement from the difference between the mid-June low and the mid-August highs. That would mean coming down to test the $400 – $401 level on the SPY (4000 on SPX) before continuing the recent uptrend.
The key level on the chart to watch is $395 (a 61.8% retracement from the recent high). A break below the 61.8% retracement typically means the end of the recent trend and you can see from the chart below that we lose any real support level below $395.
We need the PCE to start dropping and fast, but as long as it stubbornly hangs at elevated levels, the Fed will be forced to keep raising rates quickly.
I don’t see an overall collapse in the market, but I do anticipate a rocky couple of months until we get through midterm elections and a few more PCE readings. That will be just in time for Q3 earnings!
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