If you’ve been paying attention to the stock market since the Christmas Eve bear market, the S&P 500 is up 19.5%. Much of this rally has taken place in January and February 2019. If you’ve been reading the news headlines, a lot of the rally was contributed to the promise of a China trade deal. In my opinion these news headlines are wrong. Let me explain why.
Enter the Federal Reserve
Investors have a tendency to pay very close attention to the actions of the Federal Reserve board. If you’re not familiar, the Federal Reserve primarily has the task of influencing interest rates.
To illustrate this point, look at how the market reacted in the times where Jerome Powell discussed the interest rate policies of the Federal Reserve.
On October 3rd an article by CNBC, Powell said we were a long way from a neutral on interest rates. This was an indication that more rate hikes were to come.
Jerome Powell said that interest rates were extremely accommodative and that this was necessary when the economy was weak. We no longer needed low interest rates anymore. He went on to say that interest rates were still accommodative but they were moving to a place where they can finally be neutral.
What happened next?
Following these comments by Jerome Powell we saw the S&P 500 index drop through the month of October (see the red arrow above). The S&P 500 continue to experience high volatility through November and into December.
Interest rate policy uncertainty
There was a lot of fear in the market when it came to the interest rate policies of the Federal Reserve. The Federal Reserve continued to hike interest rates in December which set off a wave of selling in the market.
From December 3rd until the low point on December 26th the market dropped 16.1% of its value. This came after a slight bounce back in November following Black Friday shopping.
Jerome Powell continued to say that interest rates needed to get back to neutral. He said that the Fed was relying on the data to tell them when to stop raising rates.
The language used by Jerome Powell scared the market because they believed that the Fed would continue to raise interest rates two or three times in 2019 along with the interest rate hike that they had just completed in December of 2018.
Fear and pressure from the President
A lot of investors took this language as being quote “hawkish”. What this means is that the Federal Reserve is using tighter monetary policy which would raise interest rates and help cool down the economy and keep inflation in check.
There was a lot of fear in the market in December and Donald Trump wasn’t a fan of Jerome Powell raising interest rates.
In my opinion I think Jerome Powell faced a lot of pressure from investors and our President to take a more neutral stance on interest rates. As a result the Federal Reserve went from being hawkish to what they called dovish.
For this reason I don’t believe that any of this rally has to do with a China trade deal. I think the rally from January until February and now going in March is entirely on the back of the Federal Reserve.
I believe that a lot of investors are pricing in an interest rate cut at some point in 2019.
The Fed’s dovish opinion on interest rates combined with short-side investors getting squeezed, algorithmic trading, day traders, have all contributed to this most recent market rally.
What comes next?
We are at a level in the market that we have struggled to get over time after time.
There seems to be a lid on the value of the S&P 500 Index around 2,800 to 2820 price level. We’ve touched this price level multiple times and have only broken through the level one time since last February, when the market rallied over the summer.
It will be interesting to see how the market plays out over the next few weeks. I believe many investors have priced in the Federal Reserve decreasing interest rates at some point in 2019.
If the Federal Reserve decides increased interest rates one more time this year I think it could be extremely detrimental to the market and how they perceive things.
I don’t think an increase in interest rates should have such a drastic effect on the market, but because investors are expecting expecting a cut in interest rates instead of an increase, this could set off some pretty drastic, expected action in the market.
I believe that Jerome Powell wants to continue raising interest rates and try to get back to a more neutral level, I just don’t know if the political pressure will allow him to do so.
The case for raising interest rates is to allow the Fed some more room to cut interest rates if and when we do eventually enter into a recession in 2020 or 2021.
Conclusion: Don’t pay too much attention to headlines
Don’t believe what you see in the news. I don’t believe the market is rallying on the back of a China trade deal. I don’t think the market believes we’re going to get a China trade deal in the next two months.
I think the market is hyper focused on the behavior of the Federal Reserve and that has caused much of the volatility from October through December, and the Federal Reserve’s complete 180 on interest rate policy has also caused the market rally up to this point in 2019.