The Fed Continues to Tighten…..

Last week, the S&P500 ended essentially unchanged. Volume was very light, and volatility dipped back down to super complacent levels….not quite at the lows of the year, but close.

While the price barely moved for the week, the technical picture for the S&P is still pointing to an extremely overbought market. On both the weekly and the daily charts, prices are hugging the upper Bollinger band and show no imminent signs of backing down. Prices are back above both the 50 and the 200 day moving averages, which themselves are both sloping upwards. The current bull market cycle…while extremely long in the tooth….is not breaking down just yet.

In US macro news, last week’s reports were particularly weak. On the inflation front, the news was very disappointing. Core PPI, core CPI and headline CPI all came in well below expectations. This means that the Fed is not achieving one of its primary objectives—-nudging inflation back up to or just over 2.0% per year. Retail sales missed badly—both headline and ex-autos. Business inventories also missed. Export prices came in below expectations. The housing market index missed. Housing starts missed very badly, and consumer sentiment plunged. On the positive side, initial jobless claims were a bit better than expected, and the Philly Fed business outlook survey beat expectations. That said, the US macro data—both hard and soft measures—are now falling more severely than they have in many years.

But despite the overall weak economic data, and in particular the disappointing inflation data, the Federal Reserve continued its rate-hiking process and bumped up the Fed Funds rate by another 25 basis points. In other words, the Fed is tightening despite clearly not achieving one of its two mandates. What was even more surprising was that in the same rate hike announcement, the Fed outlined a fairly detailed plan and schedule for shrinking its bloated balance sheet by several trillion dollars. Essentially the Fed would stop reinvesting in maturing securities (such as US Treasuries) and when these securities mature, the Fed would remove the comparable amount of base money (money it created electronically to buy these securities several years ago)….so that the Fed’s lower level of liabilities and assets match.

What’s critical to understand about this is that most market experts agree that it was precisely the balance sheet expansion pf the Fed (and those of the other major central banks of the world) that has not only propped up asset prices since the Great Recession ended in 2009, but has also driven these prices to all-time record highs.

So if the primary force behind record high financial asset prices is going into reverse, then how realistic is it to believe that these asset prices can remain so high, or much less, go even higher?

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