The "rate cut dream" of the Federal Reserve is forced to be postponed. Is a major correction in the US stock market imminent?

Last week, the Pro UltrPro Shrt S&Pro 500 fell by 0.40%, marking the second weekly decline in the past sixteen weeks and breaking a five-week winning streak.

The key point is that since late October 2023, the Pro UltrPro Shrt S&Pro 500 has been on a nearly vertical upward trend. The trigger for this rebound was the dovish turn by the Federal Reserve - the Fed abandoned the "higher-for-longer" policy at the FOMC meeting in December last year and signaled a policy of "normalization".

However, considering the recent economic data (higher inflation, stronger growth), the Fed may be forced to postpone its normalization plans indefinitely, or even consider raising interest rates.

Against this backdrop, US stocks seem to face more resistance, and the Pro UltrPro Shrt S&Pro 500 may see further declines in the coming weeks. Here is a detailed analysis.

Comparison of the Fed's SEP Expectations and Data

The summary of economic projections (SEP) from the FOMC in December last year showed that the Fed expects in 2024: 1) GDP to slow to 1.4%, 2) the unemployment rate to rise slightly to 4.1%, 3) core PCE to drop to 2.4%.

The Fed hinted at cutting rates three times in 2024, from 5.3% to 4.6%, and four more times in 2025, down to 3.6%. This is a normalization policy and a soft landing scenario (no recession).

However, recent data shows:

The labor market is much stronger than expected, with the unemployment rate dropping to 3.7% in January and 353,000 new jobs added. Additionally, initial jobless claims remain very low, close to 200,000, reflecting tight labor market conditions.

Based on the core CPI index, the anti-inflation process seems to be stalled at a level well above 3%. If we use the Sticky CPI ex-shelter as a benchmark, inflation may even be accelerating. This index actually hit a low of 3.02% in November last year but has since risen to 3.25%. Some analysts believe that the unexpected 0.4% increase in core CPI inflation in January was due to housing, which was originally expected to decline significantly. However, even after eliminating housing inflation, sticky inflation continues to rise.

In addition, despite the unexpected decline in retail sales in January, the economy remains much stronger than expected, with GDPNow still predicting a 2.9% growth in GDP for the current quarter. Therefore, based on recent economic data, the FOMC may be forced to revise the SEP at the March meeting and signal less than 3 rate cuts in 2024, possibly adjusting from 0 to 2 times.

Market Expectations vs. Reality

The Federal Reserve is well aware of two key issues facing economic and financial market stability:

Firstly, there will be a significant debt maturity issue in 2025, with many companies forced to refinance their debt. If interest rates remain high before 2025, many companies may face defaults, potentially leading to credit tightening in 2025. Commercial real estate companies, regional banks, small companies, and all other weaker or "zombie" companies will be most affected. However, it will also have a systemic impact on the broader economy and markets.

Secondly, the lagging effects of previous monetary policy tightening will eventually begin to affect the economy, especially considering that pandemic-related savings may have been depleted, and student loan payments have resumed. This could lead to an economic recession, which is politically undesirable in an election year.

Therefore, the market interprets the Federal Reserve's dovish shift as a signal that the Fed aims to avoid an economic recession in 2024 and, more importantly, to address the debt maturity issue in 2025. Initially pricing in a more aggressive easing policy for 2024 - the market once expected over 6 rate cuts.

In fact, the Fed does need to significantly cut rates in 2024 to avoid the 2025 debt maturity issue, so these are reasonable expectations. However, this "hope" is based on the assumption that inflation will collapse and allow the Fed to make significant cuts. Unfortunately, current data does not support this "assumption."

Macroeconomic Background and Current Market Expectations

After the Federal Reserve abandoned the "higher-for-longer" policy in October and December last year, financial conditions significantly eased.

However, after the Fed repositioned itself as "higher-for-little-longer" at the January meeting, the market began pricing in the Fed's SEP forecasts, with the two-year Treasury yield suggesting the Fed will cut rates 3 times in 2024.

The ten-year Treasury yield and the US dollar have both risen, mainly due to the rise in real yields - indicating tightening financial conditions. Therefore, as the two-year Treasury is repriced, market expectations and the Fed's SEP forecasts will become more aligned, and financial conditions will tend to tighten.

However, despite the artificial intelligence boom, the Pro UltrPro Shrt S&Pro 500 has been rising, with the number of leading large tech stocks decreasing. Specifically, the Pro UltrPro Shrt S&Pro 500 fell after the Fed's hawkish turn in January but rebounded as the index surged 20% following Meta's (META.US) earnings report announcement. After the release of the January CPI report, the Pro UltrPro Shrt S&Pro 500 experienced a decline, but driven by NVIDIA (NVDA.US), Super Micro Computer (SMCI.US), and ARM (ARM.US), the index once again rebounded strongly.

Stock Market Under Pressure

The financial situation may further tighten as the pricing of the two-year Treasury yield reflects the Fed's three rate cuts, indicating that as real yields rise, the ten-year Treasury yield will increase, and the US dollar will strengthen. This suggests that the Pro UltrPro Shrt S&Pro 500 will further decline.

Furthermore, the Fed may also revise its SEP forecast, implying less than 3 rate cuts by 2024, which means financial conditions will tighten further. With valuation contraction, the stock market may even experience more severe selling, impacting overvalued tech stocks the most.

Another possibility is that the unexpected drop in retail sales in January may begin to show up in other data, especially in initial jobless claims, which could signal an impending economic and stock market downturn.

Regarding the artificial intelligence theme and the "bubble" in large tech companies, NVIDIA will release its earnings report after the US market closes on February 21, which could be an event that bursts the bubble.

Summary

Currently, financial conditions are tightening, and as the market and the Fed adjust to inflation reality, financial conditions may have to continue to tighten. This is a short-term negative catalyst for the Pro UltrPro Shrt S&Pro 500.

However, 1) the US economy is not yet close to the edge of recession, 2) there is no systemic credit tightening, and 3) the Fed is not expected to actually raise interest rates.

This indicates that the Pro UltrPro Shrt S&Pro 500 may just be in a pullback - technically speaking, the resistance level is the previous high point and the top of the upward channel, with the next support level around the 50-day moving average at around 4800 points.

However, this does not mean that investors do not need to remain cautious. With the approaching November election and the maturity of debt in 2025, unless the Fed significantly cuts rates, the stock market conditions will continue to deteriorate.