Could the Federal Reserve bring the stock market party to an early close?

The aim of most central banks in the world is to watch growth and make sure that inflation does not get carried away, in layman’s’ terms this means taking away the punchbowl before the party gets too raucous. This is what investors are nervous about ahead of this week’s Federal Reserve meeting, will Jerome Powell et al decide that growth is strong enough to withstand a return to their rate hiking cycle? 

This is the big question facing investors, and a Fed that brings itself back into play as a rate hiking force could end the stock market rally just as US indices hit fresh record highs on Friday. Equities are particularly vulnerable from this week’s Fed meeting as the rally in stocks has mostly been driven by valuation, rather than earnings growth, with investors happy to pick up bargains in Q1 and Q2 after the major sell off in the last quarter of 2018. 

Market tests Fed’s nerve 

After the Fed’s March meeting, where the bank moved to a neutral stance and formally announced that it was halting its rate-hiking cycle, the market is now accustomed to the Fed’s on-hold stance. However, this has not stopped the dollar from rallying to a 2-year high on Friday after the GDP report. However, although the headline number from the GDP report was impressive, growth expanded by 3.2%, well above the 2.2% expected, the details were more worrying, with growth mostly driven by inventories and external trade, both which tend to have mean-reversing tendencies. Thus, the dollar could be at risk this week. 

Interest rate expectations fail to budge after GDP report 

Interestingly, even after the stunning headline GDP figure this week, interest rate expectations from the Federal Reserve were unchanged, with the CME FedWatch tool still placing the odds of a rate cut by year end at close to 60%. Thus, considering the rapid v-shaped recovery in equities that we have seen since the start of this year, the fallout from a Fed that is more hawkish than expected could be severe. However, even though US corporate earnings season was better than many expected, the pressure is now on growth. This is where this week’s Fed meeting gets interesting. 

Will the Fed fuel US growth fears? 

As we mentioned above, the strong headline US GDP figure for Q1 masked some fairly worrying elements about the make-up of US growth. Inflation pressure was weaker than expected, which suggests that demand could be withering. If the Fed concentrates on these weaknesses and sounds concerned about the economic outlook, while dismissing the strong Q1 GDP figure, this could spook the market and cause weakness in equities and a decline in the dollar. 

The market outlook 

Both the dollar and stocks closed on a high on Friday, with US indices making fresh record highs and the dollar index reaching its highest level in nearly 2 years. We believe that prices could be fairly stagnant until the Fed meeting on Wednesday, however, the bias for both the dollar and stocks could be to the downside, particularly if the Fed sounds a warning sign about the US’s growth prospects. 

Euro fortunes rely on Spanish election outcome 

The euro is also on our watchlist this week. After declining below $1.12, the market is watching the outcome of the Spanish general election. Early results suggest that the Socialists have won the most seats, however they may have to form a coalition with Catalan separatists to form a government. The early results also suggest that the ultra-nationalist Vox party has won a sizeable number of seats, and it will be the first time that a far-right party will have won a sizable parliamentary representation in Spain since the death of the Dictator Franco. This could spook euro traders even more, as the market weighs up the chances of Spain either breaking up, due to Catalan separatist demands, or of anti-EU sentiment from Vox parliamentary members. EUR/USD has come under pressure since the early open on Sunday evening as investors’ digest these results, right now $1.1142 is the low, however, sellers continue to emerge at $1.1150, which is making it hard for the euro to gain traction to the upside, and suggests to us that the path of least resistance is further downside. Last week’s low at $1.1125 is now in view. 

Elsewhere… 

Financial traders will be mostly Fed-watching this week, and this could mean that it is a slow start as the market waits for direction from Jerome Powell et al. However, elsewhere, there are some key banking earnings from the Far East, including HSBC and Standard Chartered, as well as Eurozone GDP for Q1, global PMI reports, the BOE decision and the all-important US payrolls report for April at the end of the week. Please read Thursday’s report for our NFP preview.