Understanding the Federal Reserve’s Decision and Its Impact on the Stock Market

The Fed’s Rate Decision and Aggressive Language

This week, the Federal Reserve made an important announcement regarding interest rates. In a surprising move, the Fed decided to pause its rate-raising cycle, signaling a temporary break in the tightening of monetary policy. However, despite this pause, the Federal Open Market Committee (FOMC) used aggressive language to suggest that higher rates are still on the horizon.

The combination of the rate pause and the FOMC’s language had an initial impact on the stock market, resulting in a brief pullback. However, the market quickly rebounded, with the S&P 500 (SPY) and other indices returning to a bullish form.

While this news may be reassuring for investors, it’s important to recognize that market optimism can only do so much for our portfolio. The performance of our smaller holdings, despite being uncorrelated in terms of market capitalization, tends to benefit from a rising tide. Regardless, let’s dig deeper into the details.

The Fed’s Decision and Inflation Trends

As anticipated, the Federal Reserve chose not to raise rates during the June FOMC meeting. This decision came on the heels of an expected drop in the Consumer Price Index (CPI), a popular measure of inflation. The CPI for the month of June came in at 4%, significantly lower than the previous month’s 4.9%.

The decline in inflation likely played a role in the Fed’s decision not to raise rates this time. However, the FOMC’s aggressive language indicated that there is still a strong possibility of a quarter point rate hike in July. The central bank emphasized that it has more work to do before achieving its target inflation number.

Impact on the Stock Market

Despite the Fed’s warnings, the stock market showed resilience. Following a brief pullback in major indices, stocks rallied at the end of Federal Reserve Day. Additionally, the S&P 500 (SPY) experienced a 1.2% increase the following day.

The accompanying chart clearly indicates that the SPX (S&P 500 Index) is currently above the two standard deviation upper barrier. Although volatility has increased, the breach is not as severe as it would have been a week ago. It is reasonable to expect a mean reversion in the upcoming week as buying subsides.

While it is unlikely for stocks to experience a significant selloff over the next month, mean reversion remains a reality. The market will eventually return to its median price, even though stocks are currently on a rising trajectory.

Additionally, retail sales exceeded expectations, indicating that consumers are continuing to shop despite inflationary pressures. This factor further complicates the Fed’s predicament, as they must carefully balance economic growth and inflation reduction.

The Road Ahead for Interest Rates and Volatility

Looking ahead, it is reasonable to expect a few more rate hikes this year before the Fed reaches a point of stability and eventually sees lower rates. It is likely that we will have to tolerate higher rates for another year or so.

In terms of volatility, the index has experienced a slight increase leading up to the Fed’s announcement but has since dipped back below 15. All indicators suggest that we are likely to experience a continued low volatility regime during the summer trading months. However, it is important to note that volatility may rise as the July FOMC meeting approaches.

Considering the upcoming July 4th holiday, a period known for low market volatility due to reduced trading activity, it is unlikely for significant volatility spikes to occur during this time.

Expanding on the Topic: Factors Impacting the Stock Market

While the Federal Reserve’s decision and its impact on the stock market are undoubtedly significant, it is crucial to consider the broader factors that can influence market performance and investor sentiment. Some additional areas worth exploring include:

1. Global Economic Conditions

The global economic landscape plays a crucial role in determining the trajectory of the stock market. Factors such as trade tensions, geopolitical events, and the performance of major economies all have the potential to impact market sentiment and investor behavior.

For example, the ongoing US-China trade dispute has created uncertainty in global markets and has the potential to disrupt supply chains and economic growth. Investors closely monitor developments in trade negotiations to gauge potential impacts on investment opportunities.

2. Corporate Earnings and Valuations

The performance of individual companies and their earnings reports can significantly affect stock prices. Positive earnings surprises often lead to stock price appreciation, while disappointing results can trigger declines.

Furthermore, the valuation of stocks, as measured by metrics like the price-to-earnings ratio (P/E ratio), can provide insights into whether a market or specific stock is overvalued or undervalued. Investors often assess valuations to determine the attractiveness of certain investment opportunities.

3. Investor Sentiment and Behavioral Finance

Investor sentiment, which reflects the collective emotional state of market participants, can strongly influence market trends and price movements. Market psychology and behavioral biases can lead to irrational decision-making, causing significant volatility and market inefficiencies.

Understanding the impact of investor sentiment and behavioral finance is crucial for investors and traders seeking to navigate the stock market successfully. Recognizing and managing these emotional biases can help investors make more rational and informed decisions.

Summary

The Federal Reserve’s decision to pause its rate-raising cycle, coupled with the aggressive language from the FOMC, had a limited impact on the stock market, which quickly rebounded from a brief pullback. The S&P 500 and other indices returned to a bullish form, indicating market optimism.

Despite the positive market sentiment, mean reversion remains a reality, and the market is likely to return to its median price at some point. Additionally, ongoing factors like global economic conditions, corporate earnings, and investor sentiment continue to shape market performance and investor behavior.

As we move forward, it is essential to monitor these factors closely and adjust our investment strategies accordingly.

The big news this week came from the Federal Reserve, with a pause in the rate-raising cycle coupled with aggressive language from the FOMC (higher rates to come). However, after a brief pullback in stocks, the S&P 500 (SPY) and other markets have returned to bullish form. We’ll get back to that in a bit, but the good news for us is that optimism can only help our portfolio. Despite the uncorrelated nature of some of our smaller holdings (in terms of market capitalization), a rising tide tends to lift all boats. Read on for more….

(Enjoy this updated version of my weekly comment originally posted on June 15^he in it POWR Stocks Under $10 Newsletter).

As expected, the Fed decided not to raise rates at the June FOMC meeting. This comes on the heels of a further expected drop in the CPI. The popular inflation measure came in at 4%, which was significantly lower than the previous month’s 4.9%.

The apparent decline in inflation may be one reason the Fed felt comfortable not raising rates this time.

However, the FOMC had no qualms about being aggressive with its language. There is almost a 70% chance of a quarter point rate hike in July. Furthermore, the central bank has made it clear that they have a lot of work to do before arriving at their preferred inflation number.

However, the Fed’s warnings made little difference to the stock market. After a brief pullback in the major indices, stocks rallied at the end of Federal Reserve Day. And on Thursday, the S&P 500 (TO SPY) rose another 1.2%.

You can see from the chart above that the SPX (S&P 500 Index) is clearly above the two standard deviation upper barrier.

The volatility has picked up a bit, so the breach is a bit less severe than it would have been a week ago. That being said, I would expect a mean reversion next week as buying subsides.

That’s not to say that stocks won’t continue to rise on average. In fact, at this point, I would be surprised by any significant selloff over the next month or so.

Still, as I often say, mean reversion is a real thing, and at some point, the market will return to its median price.

Meanwhile, the economy continues to huff and puff. Retail sales also beat expectations this week (rising 0.3% in May) as consumers continue to shop despite above-normal inflation.

The Fed has an interesting situation on its hands. Do they want to risk torpedoing the economy? Or should you focus primarily on reducing inflation?

We’ll see how things play out, but I would expect a couple more rate hikes this year before we’re in a position to hold steady (and eventually see lower rates). We may be stuck with higher rates for another year or so at this rate.

Volatility rose a bit ahead of the Fed’s announcement, but dipped back below 15 on Thursday. All signs point to a continued low volatility regime for the summer trading months. You can see the VIX action on the chart below.

Other than some unexpected news, I would not expect any significant rise in the VIX level until we get closer to the July FOMC meeting.

Keep in mind that the July 4th holiday is the prime travel season and there is not likely to be much volatility during that period.

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All the best!

jay solooff
Chief Growth Strategist, StockNews
Publisher, POWR Stocks Under $10 Newsletter

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SPY shares closed at $439.46 on Friday, down $-3.14 (-0.71%). So far this year, SPY has gained 15.35%, versus a percentage increase in the benchmark S&P 500 index over the same period.

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About the author: Jay Soloff

Jay is the Lead Option Portfolio Manager at Investors Alley. He is the editor of Floor Trader PRO Options, an investment advice that offers you professional options trading strategies. Jay was previously a professional options market maker on the CBOE floor and has been trading options for over two decades.

Further…

The charge Reading between the lines of the latest FOMC statement first appeared in stocknews.com