For weeks the market has been shrugging off indications that interest rates are going higher for longer. Hot economic data has been ignored, and clear hawkish signs from Fed members and Chairman Jerome Powell have been ignored.
A big part of why the market has been fighting the Fed has been high levels of liquidity and poorly positioned bears. There has been a consistent squeeze when the bearish narrative of high-level strategists failed to materialize. The theory was that poor earnings reports would trigger increased concerns about corporate growth and cause the market to anticipate a recession. That did not happen, and all the pessimists who embraced that scenario turned into short-squeeze fodder.
Over the last couple weeks many of the shorts have been squeezed out, but there is still some liquidity supporting the bullish narrative. The bulls have embraced the theory that inflation is cooling but that the economy is staying strong, and they believe the Fed will be able to navigate the economic challenges with little downside to the stock market.
It is a nice theory but wildly optimistic and not supported by much of the recent economic news. On Thursday, there was another hint that the Fed would need to stay hawkish for longer when the latest Producer Price Index (PPI) numbers were hotter than expected. The market tried to shrug this off just like it ignored a hot Consumer Price Index report and huge growth in jobs, but two Fed members mentioned the potential for increasing the next rate hike to one-half percentage point rather than 25 basis points and the market finally cracked and closed at the lows of the day.
The negative momentum is carrying over. Early indications for Friday's open are poor. Treasury yields are increasing, the dollar is stronger, and fed funds futures reflect that rates will hit 5.2% by July.
Do the bears finally have some traction? Is the market finally ready for some corrective action after a great January?
Seasonality in the second half of February tends to be quite poor, and the charts don't have a lot of great nearby support. The path of least resistance is down, but strong markets tend to stay sticky to the upside for a while as dip buyers generally will try several times before they become discouraged and give up.
The bulls' primary argument for more upside is that the economy is strong and so is the job market, which will help the market even if rates go higher. That is a questionable belief.
The problem for the bulls is that the strong economy is going to keep inflation at higher levels, which will lead to more rate hikes for longer. At some point, that will hit the economy. Bank of America strategists say that the recession is being pushed back and will weigh on stocks in the second half of the year.
In the near term, the bears finally have traction, and we will see if they will build downside momentum. We have a three-day weekend coming up, plus it is option expiry, so watch for late-day volatility.
