Stock market rally won’t be wiped out by Fed after neutral rates: Fundstrat

  • According to Fundstrat’s Tom Lee, Fed Chairman Jerome Powell doesn’t have to kill every stock market rally.
  • That’s because the Fed is likely to raise interest rates to its neutral target of 2.5% this week, he said.
  • “Risk/reward tends to be bullish at 2 o’clock, [and] “If inflation calms down, the Fed won’t have to kill every equities rally,” Lee said.

The Federal Reserve has had a knack for killing stock market rallies in recent months as it raised interest rates aggressively to combat a 40-year spike in inflation readings.

But that trend may end soon, according to a Monday note from Fundstrat, as inflation begins to subside and the Federal Reserve reaches its neutral target rate of 2.5%. The Federal Reserve is expected to raise interest rates by 75 basis points on Wednesday, which will put the upper limit on the federal funds rate at 2.5%.

The Fed’s target neutral interest rate is defined as not stimulating or restricting overall economic growth.

In fact, after the July FOMC, the entire yield curve will be above the “neutral” rate: meaning the bond market is doing the Fed’s job. [and] He told me that all the money cost is above the neutral rate.”

Reaching the neutral rate means that the Fed will have more options in the path of a future rate hike and will be able to respond better to inflationary data. With signs of inflation emerging, as evidenced by lower commodity prices, this is setting the stock market up for further upside in the second half of the year as it allows the Federal Reserve to pause interest rate hikes.

“If the pace of inflation is declining faster than the consensus expects, the rally in stocks reflects a ‘downside surprise’, and therefore, the Fed does not need to eliminate the rally,” Lee said.

Ultimately, he sees some parallels between the current path of Fed rate hikes and the rate hike cycle established by former Fed Chairman Paul Volcker in the early 1980s. In that time, the S&P 500 is down 27% and the economy has experienced a “manufactured” recession from which it is relatively easy to recover.

Market action in the early 1980s is roughly in line with the stock market’s peak-to-bottom drop of 25% so far this year, while US GDP growth is on the verge of contracting for two consecutive quarters, which many consider a technical slump.

“The duration of inflation is much shorter today, so the 25% drop looks like it’s overstepped,” Lee told me, noting that internal market assessments have slipped in recent weeks, along with investor sentiment readings.

“Risk/reward tends to be bullish at 2 o’clock, [and] If inflation subsides, the Fed won’t have to wipe out every rally in equities…so we’re seeing a rally around the clock.”

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