Coming into Tuesday, the S&P 500 had held the 3890 level and bounced back above its 50-day and 100-day moving averages. The market seems to be in a short-term uptrend. As we head into a notable Triple Witching options expiration this Friday, the derivative setup is key in driving the direction of the markets now.
Given the level of open interest centered between the 4000 and 4200 strikes, it just makes the market jitterier as the market makers need to be risk neutral following the expiration. This tends to distort the true underlying fundamental picture and hence makes the rally self-fulfilling as the FOMO retail traders and algos step in lest they miss the bottom.
The key debate in the market right now is whether or not the Fed is about to or will pivot from its hawkish stance. These are unusual investment times when the only rational to "invest" in the market is whether or not Daddy Fed will hand out more candy to its "children."
There is also a lot of press around the August CPI report that was announced Tuesday morning where the market expected an 8.1% increase in the year-over-year rate but a Core CPI increase of 5.1%. But that didn't happen and it's now likely that the Fed will continue to sharply raise interest rates given the higher-than-expected August CPI reading that saw the markets in full retreat.
(For more on the August CPI reading, see here and here.)
Inflation prints may be lower going forward given the excess of all input costs seen during the summer, but the real debate is whether they will be low enough for the Fed to feel comfortable that their job is done. The jury is still out on that one. The eagerness of investors may whipsaw the market in many directions before its true trend will be found.
The Fed has been clear during their press conferences that they are focused on getting the long-term inflation rate down to 2%. Of course if the economic situation would turn sour or if employment were to be an issue, they could reconsider, but it does not seem that that is an issue for right now. The market has rallied about 5% since the lows on back of these "hopes" and may be getting ahead of itself. The Fed has never really played a pre-emptive role, but more a reactionary one.
The Dollar's Damage
The dollar strength has caused a lot of damage given the world is indebted in dollars and its huge rally is hurting the consumption trends of emerging market economies and rest of the world. The greenback has rallied 15% against the yen, and that is a huge historical outperformance vs. a developed market currency. But both have systemic problems given their specific economies as Europe battles with a huge debt pile and secular inflation mixed with lack of efficient energy policy.
Japan has been dealing with a defunct currency as its central bank keeps printing yen to support its domestic bond market. They face the choice of either yield curve control via letting their currency fall, or risk a disorderly bond market. The latter is not an option but as the Bank of Japan keeps buying back more and more bonds, the yen has no choice but to depreciate.
This is putting an inordinate amount of pressure on the other Asian currencies, with the yuan trading close to the 7 level, which has been a key psychological level for the PBOC to devalue. Whether or not it does, remains to be seen, as it is clearly losing its competitive advantage vs. the other Asian currencies.
All eyes are on Fed Chair Jerome Powell as he presides next week during the September FOMC meeting where a 75 basis point rate increase is expected. But it is not about it being a 50 bps or 75 bps -- it is about the inflation outlook that is more important for all risk assets and will be the key-driving factor.
The Fed has to navigate itself very smoothly through an extremely tough set of economic conditions. It can either choose to appease investors, giving them yet another short-term fix, or take the long-term approach by devaluing assets, making sure inflation never comes back to haunt them. Given the way geopolitics is headed, we would hope the Fed chooses the latter.
