2023-11-30 08:59:08 ET
Summary
- The S&P 500 rallied 10% in November as the financial conditions loosened with the lower interest rates and a weaker US dollar, after the November 1st FOMC meeting - where the Fed paused.
- Fed Chair Powell's upcoming speech is expected to be more hawkish, potentially ending the current stock market rally.
- Powell is likely to reiterate the need for tighter financial conditions, and possibly put another hike on the table.
The November Rally
The S&P 500 ( SPY ) is up by 10% over the last month, with almost a vertical rise from the October correction lows. Here is the chart:
Let's first understand the cause of the August-October 10% correction. After the June-July rally, S&P 500 stalled as the interest rates started to rise in late July. The yield on 10Y Treasury Bond crossed the 4% level in late July and kept rising until mid-October when it reached 5%. Similarly, the Fed kept forcing the higher-for-longer narrative, suggesting that the Federal Funds rate would have to go to 5.50-5.75% range by the end of 2023. Thus, the stock market corrected by 10% in reaction to the higher interest rates - that was a valuation contraction correction.
However, the jobs data at the beginning of November showed a slight weakening in the labor market, which was later supported with lower-than-expected CPI inflation data. Thus, the yield on 10Y Treasury Bond started to decrease due to the expectations of a slowing economy, falling to 4.27%. In addition, the market started to price the Fed cuts, supported by some dovish statements from the FOMC members, so the 2Y Treasury yields fell to 4.73% Thus, as the interest rates started to fall, the stock market started to rise - the valuation multiple started to expand again.
Here is the chart on 10Y and 2Y Treasury yields.
It is very likely that the market action in November was due to a major short covering. Specifically, the market participants covered their crowded short positions in stocks and bonds - which explains the sharp moves in both asset classes.
Yet, some analysts/commentators try to justify the move fundamentally. Specifically, the bullish narrative is as follows: Inflation is falling, thus, the Fed will aggressively lower interest rates in 2024, which will cancel the expected recession. This is a soft-landing or no-landing scenario, really a 1995-like scenario.
The bulls look for any clue from the FOMC member speeches to justify the bullish narrative, and there were some borderline dovish speeches, possibly suggesting that the Fed could cut in 2024, such as the recent Waller speech.
But, the reality is much different, and the Fed Chair Powell will have to "pour cold water" on the bullish narrative, when he speaks on Friday.
The Powell speech on Friday
The Fed Chair Powell will speak on Friday, for the last time before the December FOMC meeting. What will he say?
First of all, at the November FOMC meeting, Powell suggested that the Fed would not have to increase the Federal Funds rate to the 5.50-5.75% range, as previously stated. That suggested that the Fed officially finished the interest rate hiking campaign at 5.25-5.50% level. So, this was dovish, based on the market view.
But, Powell also stated that the sharp increase in long term rates substitutes for another hike by the Fed, which is why the Fed could pause. Let's see what Powell actually said at the November 1, 2023 Press Conference after the FOMC meeting, which triggered the stock market rally:
So, obviously we’re monitoring, we’re attentive to the increase in longer-term yields and—which have contributed to a tightening of broader financial conditions since the summer. As I mentioned, persistent changes in broader financial conditions can have implications for the path of monetary policy. In this case, the tighter financial conditions we’re seeing—[coming] from higher long-term rates, but also from other sources, like the stronger dollar and lower equity prices —could matter for future rate decisions, as long as two conditions are satisfied.
The first is that the tighter conditions would need to be persistent . And that is something that remains to be seen. But that’s critical. Things are fluctuating back and forth—that’s not what we’re looking for. With financial conditions, we’re looking for persistent changes that are material.
The second thing is that, that the longer-term rates that have moved up—they can’t simply be a reflection of, of expected policy moves from us that we would then—that if we didn’t follow through on them, then the rates would come back down . So, and I would say on that, it does not appear that an expectation of higher near-term policy rates is causing the increase in longer-term rates.
So, in the meantime, though, perhaps the most important thing is that these higher Treasury yields are showing through to higher borrowing costs for households and businesses and those higher costs are going to weigh on economic activity to the extent this tightening persists and the mind’s eye goes to the 8 percent—near 8 percent mortgage rate, which could have pretty significant effect on housing.
Thus, Powell specifically stated that he needs the financial conditions to remain tight for the Fed to be able to pause, meaning the interest rates to stay high ( TLT ), US Dollar ( UUP ) to stay strong, and equities to stay "lower". He even mentions 8% mortgages. Well, since this statement, the US Dollar significantly weakened, interest rates fell, and the stock market rallied - the financial conditions loosened significantly.
Thus, Powell will have to reiterate his message that the financial conditions have to remain tight for the Fed to be able to pause, otherwise, another hike could be coming - this message is likely to end the recent stock market rally.
The alternative scenario is that the Fed is aware of the data not publicly available that indicates an imminent recession. In this case, Powell could suggest that interest rate cuts are coming, but this is not a dovish message, this is actually a major negative for the stock market - the Fed generally cuts when something breaks, and that's when the stock prices are falling the most.
What led the recent rally?
Specific SPY sector analysis shows that all sectors bounced strongly in November, except energy ( XLE ). However, the 14% bounce in REITS ( XLRE ) is the unsustainable reaction to lower interest rates and short-covering of the heavily shorted ETF. Similarly, the financials ( XLF ) bounced strongly, with the regional banks ( KRE ) up by 15% in November. The Technology sector ( XLK ) ( QQQ ) continued the magic outperformance, with a nearly 15% rise in November. Thus, it appears that there was a major short covering of heavily shorted sectors in November, and also the continuation of the AI-themed tech story.
SPY is an ETF that tracks S&P 500 ( SP500 ) most popular with institutional and retail investors, with 430B in AUM, 0.09% fees, and a very high 13% short interest.
Implications
The vertical rally in the stock market in November was likely a short-covering rally, triggered by the fall in interest rates in the aftermath of the FOMC meeting on November 1st. Powell suggested on November 1st that the Fed could pause if the financial conditions remain tight, specifically referring to higher long term interest rates, stronger US Dollar, and lower equity prices. However, the financial conditions significantly loosened since Powell's November 1st statement. Thus, Powell will have to be more hawkish in his Friday speech, which is likely to end the current rally in SPY. Unless, of course, Powell signals that a recession is imminent, which is even more bearish for stocks. Either way, SPY is still a Sell.
For further details see:
SPY: Powell's Friday Speech To Likely 'Kill' The Rally