Inflation, The Fed, And The Summer Rally

Key Points

• The CPI data cooled, but investors should not expect the Fed pause to last long. 
• Core CPI is still hot, and the odds for another hike are rising. 
• The S&P 500 rally may hit a new all-time high, but the higher it gets, the more likely a sharp correction will follow. 

The market is climbing a wall of worry and may rally into the summer. How high it gets and what happens then is anybody's guess at this point in the game, but upward movement persists. And this is despite an iffy read on the Consumer Price Index that points to additional tightening later this year. The headline CPI figure was good; it subsided substantially on an MoM and YoY basis and suggests the Fed’s work is done.

However, details within that data indicate lingering inflation that does not support the idea of Fed policy easing. On the contrary, the core figures were flat and as expected compared to the previous data, which was hot. 

Core Inflation Is Hot, The FOMC Will Raise Rates Again

At the core level, and the core level is what counts because that’s what the Fed is watching, inflation is still running at 0.4% monthly and 5.3% YOY. The 5.3% YOY is down compared to last month, about 0.2%, but only as expected and still more than double the Fed’s target. This data will not sway the Fed’s decision in June because they watch the PCE price index more than the CPI, but this data suggests the following PCE index will still be hot.

The last read on the PCE index showed core consumer inflation accelerating from the previous month and trending above 4.5%. It is still more than double the Fed’s target, with no reason to believe it will subside substantially. The next release of PCE data is due on June 30th and will be a market-moving event. 

The CPI data moved the needle on the CME’s FedWatch Tool but not so much for June. The June odds shifted a little, and in favor of a pause, the odds for July, September, and the 2nd half of the year are concerning. The FedWatch Tool indicates the market is pricing in a near 75% chance for another rate hike in July or August, maybe both, and it could be as much as 50 basis points.

That puts interest rates well above the 525 peak rate indicated and priced in for the last 3-4 quarters and the S&P 500 NYSEARCA: SPY at risk of correcting. Worse, the market pushed out the peaking of rates to November and even then, the odds are low for a cut. Even so, if the Fed acts as the FedWath Tool suggests, the core FOMC rate will be above 5.0% at the end of the year, which is not priced into the market. 

The Earnings Outlook Continues To Decline 

The market's true driver, the earnings outlook, stabilized over the last few weeks but is still trending lower. The outlook is pressured by rising prices, rising rates, and a shift in consumer spending that will result in a pullback in discretionary spending, if not consumer spending in general.

If that trend continues in the Q2 earnings cycle, it will likely cap gains for stocks, but there is a caveat. The caveat is that earnings growth, however tepid, is expected in the 2nd half and could lend market support. AI is fast becoming a driver of the outlook, which is also favorable, and will lend support to the market. The takeaway is that sector rotation may take hold of the market and drive volatility, if nothing else. 

The post-CPI S&P 500 futures action was volatile and mixed but left the market moving higher by the opening bell. The action indicates fear of the fed is diminishing; however, misplaced, and that could allow the market to rally. The S&P 500 is above the critical 4,300 level and has no significant resistance targets until 4600, about 4.5% above the current action. If the market can get above there, it will be within a shot of the all-time highs. By then, the PCE report will be out, and Q2 reporting will be in full swing.