The sell-off in risk continues, as pre-Fed meeting nerves set in

Next week is the first Fed meeting of the year and it is expected to show a Fed that is willing to stamp out inflation with interest rate hikes and shrinking its balance sheet, possibly at the same time. In recent years, we have come to expect traders and investors to buy the dips, which has limited stock market losses and helped fuel a super bull cycle. Price action so far this week tells us that this behaviour is over. An environment where the Fed is tightening, and possibly aggressively so, is one where everyone is terrified to buy the dip and instead, we are seeing a mentality emerge: selling any rallies. That is certainly the case for the Nasdaq. On Wednesday it fell into official correction territory and is down 7% since the start of the year, which is leaving stock market bulls feeling queasy as the Nasdaq has a track record of delivering double digit returns. On Thursday it looked like a recovery rally was on the cards, however, a late bout of selling weighed on the tech stocks and the market overall, so the Nasdaq Composite Index actually fell 1.3% by the close. Where stocks go next could depend on what the Fed says next week. 

2 factors to consider when deciding what your next trading move

There are two key things that we think are worth looking at if you are a trader right now. The first is an evaluation of the chance of 4 interest rate hikes from the Federal Reserve this year. The CME FedWatch Tool is currently pricing in a more than 91% chance of rate hike to 0.25-0.5% for the Fed Fund Rate in March. There is more than a 40% chance already priced in for a Fed Funds rate of 0.75-1% by the middle of this year. This is an aggressive pace of tightening and there is a growing chorus of analysts who think that the market has been too hasty pricing in rate rises, added to this, the 30-basis point jump in the 2-year Treasury yield so far this year could also be ripe for a pullback. We would note that the Citi Group Economic Surprise Index has turned negative for the year, which is a sign that the US economy is already cooling. While this is usually bad news for global stock markets, it could give the Fed pause for thought on the aggressiveness of its hiking cycle. While we think that a March rate hike from the Fed is now a given, a weakening economic backdrop could do some of the hard work for the Fed and require fewer rate hikes from them. If the Fed references the recent spate of weaker than expected US economic data at its meeting next week then we could see a rapid repricing of interest rate expectations, which may see a surge higher in the Nasdaq and stocks more broadly. Thus, there could be plenty of volatility to come in the next few days. 

S&P 500 earnings season on track to beat expectations 

The second point we would note concerns earning season. While it is early days, of the 20 S&P 500 listed companies who had reported their Q4 results as of the 18th January, 76% reported earnings that were above their mean EPS estimates, and on average these companies have beaten EPS estimates by 7.5%. Thus, both the number of companies reporting earnings above their estimates and the magnitude of the earnings beat is close to the 5-year average. This suggests that earnings growth for the S&P 500 could be close to 30% for Q4, according to data-gatherer FactSet. Thus, decent earnings growth for Q4 could also act as a buffer in the medium term to a more prolonged and deeper downturn for stocks. 

Tech earnings season and the outlook for the Nasdaq 

However, in the short term, news that Netflix had added 8.3 million subscribers in the latest quarter, which was slightly fewer than it had predicted, sent its shares lower in after-hours trading. At the time of writing, the Nasdaq 100 e-mini future was pointing to another 2% drop for the tech-heavy index at the end of the week. If the tech sector is a weak link this earnings season, there could be plenty more pain for the Nasdaq to come, especially if the Nasdaq 100 breaches its 200-day sma at 15,000 after conclusively breaching its 100-day sma. This sell-off in the Nasdaq comes at a difficult junction for tech stocks: multi-month lows, expected Fed rate hikes and some big tech names reporting earnings in the next two weeks, with Microsoft kicking things off on 25th January, is a heady mix of risk-factors. We will talk more about Microsoft next week, however, if we get a decent set of earnings from the tech giants, then the Nasdaq 100’S 200-day sma could be protected and it could ignite a recovery trend. 

FX: the wallflower in the investing world 

Elsewhere, China cut its key interest rates on Wednesday at the same time as the Fed is contemplating hiking rates. This divergence in the global hiking cycle may be calming fears about a harsh economic fall out, however the performance of US shares on Thursday suggests that the Fed is the only story in town right now. As stocks are selling off and the Vix volatility index has moved higher, the dollar is also rising. It rose against the euro and the pound on Thursday, with GBP/USD falling below the $1.36 level in late trading. A break below $1.3580, an established support level since 11th January, then we could see more pain for this pair as political problems for Boris Johnson and a potential leadership challenge weighs on sterling. Whilst we had been bullish on sterling at the beginning of the year, the unexpected political events means that we are more wary of GBP’s fortunes in the short to medium term. For now, FX is less volatile than stocks and bonds, we think that volatility could return, but it may take a very hawkish Fed to give the dollar the kick it needs to see another attempt at breaking the 97.0 level in the dollar index.