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Could the Fed’s Rate Reversal Lead to More Volatility in the Stock Market?

Inflation has become a recurring theme in my comments due to a notable rise in inflation metrics and how they have affected the S&P 500 (SPY). The Fed has consistently spoken of inflation being transitory over the past couple of months, which has resulted in investors becoming less concerned over higher prices. But it appeared that the Fed reversed course as it is now, indicating it would raise rates ahead of schedule. This created more volatility in the markets leading to a tough day on Friday. But, if you look closer at their remarks, not everything is as it seems. I will expand on my point below. But first, let's recap the past week in the markets. Read on below…

Stocks finished lower last Tuesday after investors digested a slew of economic data ahead of Wednesday's Fed decision. The S&P 500 and Nasdaq composite fell from their record closing levels. Retail sales fell more than expected in May, as consumers spent less on big-ticket items such as cars, and producer price index data came in higher than expected, which stoked inflation fears.

The market closed down on Wednesday after the Fed signaled it expects to increase the benchmark lending rate ahead of schedule. Though the Fed kept interest rates and asset purchases the same for the time being. Fed Chair Jerome Powell indicated that support would stay in place in his post-meeting press conference.

On Thursday, stocks continued a rotation into growth-oriented names as investors didn't seem too bothered by the unexpected shift from the Federal Reserve. Initial jobless claims rose to 412,000, higher than the expected 359,000 and last week's 375,000. This rise isn't too concerning, though, as initial claims are expected to continue to decline over the medium term.

The markets were spooked on Friday from comments by St. Louis Fed President James Bullard. Bullard said he expects the first interest rate hike to come next year, which is faster than indicated in Wednesday's meeting. As a result, stocks fell as investors became more concerned that support would be removed even faster than expected.

The Dow fell 533 points, ending its worst week since late January. Stocks that have benefited from a more robust economy were hit the hardest. However, the markets bounced back today as St. Louis Federal Reserve President James Bullard noted that taper discussions were just starting and that it will be a while before anything is implemented.

Plus, Dallas Fed President Robert Kaplan weighed in and reiterated that the Fed would gradually withdraw its support. This means that the Fed's easy money policies are here to stay for at least the near term. As a result, the Dow gained 587 points, and value stocks were the biggest beneficiaries as the reflation trade returned.

Market Outlook

While the Fed may have changed its stance, it does not change my view over the near and mid-term. This is certainly the most hawkish the Fed has been since the start of the pandemic, but the central bank still seems to be remaining accommodative for the time being.

Much of the recent price increases are due to supply shortages caused by the pandemic and a lack of labor to meet numerous open jobs. So, I expect more volatility in the near term as economic data has been erratic. Still, once we get past these pandemic-driven supply shortages, we should get a clearer picture of the economy.

I believe the biggest threat to the markets would require a sudden tightening in monetary policy. This would undoubtedly cause damage as it would send interest rates up, make credit spreads wider, and result in lower stock prices, but I doubt the Fed would do that.

This week, my eyes are on existing home sales in May. Prices have been rising as there is limited inventory. I am interested to see if buyers are slowing their purchases in the face of these higher prices. Plus, I will be looking out for the PCE price index, which serves as the Fed's official inflation gauge.

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All the Best!

David Cohne
Chief Value Strategist, StockNews
Editor, POWR Value Newsletter

SPY shares were trading at $422.25 per share on Tuesday afternoon, up $1.39 (+0.33%). Year-to-date, SPY has gained 13.31%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: David Cohne

David Cohne has 20 years of experience as an investment analyst and writer. He is the Chief Value Strategist for and the editor of POWR Value newsletter. Prior to StockNews, David spent eleven years as a consultant providing outsourced investment research and content to financial services companies, hedge funds, and online publications. David enjoys researching and writing about stocks and the markets. He takes a fundamental quantitative approach in evaluating stocks for readers.


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