SPX500 Set 15-Month Lows on Monday & Closed in Bear Territory, Ahead of the Fed

US Inflation Surge

US Inflation had shown signs of easing recently, since the headline Consumer Price Index (CPI) had backed-off to 8.3% in April (year-over-year). This had created some hopes for a peak in Inflation, but these were shuttered last Friday, as the latest data revealed another surge.

Headline CPI climbed to the highest level since December 1981, coming in at 8.6% in May year-over-year, although the Core reading which excludes food and energy prices eased to 6% year-over-year, from 6.2% prior.

More to it, preliminary data from the University of Michigan, showed that Consumer Sentiment took a nosedive to 5.2 in June, marking a 14% decline from May and the lowest value in record.

Aggressive Fed Hike Bets

The US Federal Reserve has made fighting inflation its top priority and has embarked on a front-loaded tightening path, having already hiked interest rates two times. We have also seen a series of hawkish commentary recently from policy makers, highlighting their willingness to keep tightening after the summer and reaffirming the bank's resolve to bring priced down.

After the May meeting, Mr Powell had pointed to more half-percentage moves in June and July, but had ruled-out more aggressive 75 basis point increases, saying that this is "not something the Committee is actively considering" ^[1]. Given Friday's renewed inflation surge however, the Fed may be forced to consider such action.

The central bank will hand down its latest policy decision this Wednesday and breaking away from its well-telegraphed path could roil the already tumultuous bond and stock markets. Even if it does not offer a surprise with a larger hike, investors will be definitely looking for hints on the bank's intention for July and beyond, while the updated staff projections will be another focal point.

The recent data have definitely caused a massive repricing in market expectations for the Fed's tightening path, since CME's Fed WatchTool now projects a bigger 75 basis points hike this Wednesday, with 93.7% probability at the time of writing. Another equal move is projected for the next meeting in July, with 69.9% probability. ^[2]

Fears of Stagflation

The expectations for an even more aggressive tightening cycle by the Fed after the last inflation print, has increased fear of stagflation. According to last month's preliminary data (second reading), US GDP contracted by 1.5% in the first quarter, although Fed officials have largely dismissed a recession – typically defined as two consecutive quarters of contraction.

As we have commented before, mr Powell's commentary of a "soft or softish landing" ^[1], does not inspire much confidence in the Fed's ability to tame inflation without plunging the economy into a recession and causing another rise surge in unemployment. Furthermore, it has lost some credibility with its prior "transitory" narrative, which increases the risk of a policy mistake.

SPX500 Analysis

The new surge in inflation, expectations for a more aggressive monetary action by the Fed, fears of stagflation and other factors, sparked a fresh wave of risk aversion, which was evident in the bond and stock markets.

This did not only send SPX500 to its lowest levels since March 2021 on Monday, but also to a close in bear territory. The index had managed to avoid this last month, but ended Monday with more than 20% loss from its January record highs, which is generally considered the threshold for such a designation.

This caused to a resumption of the downtrend - perhaps a little bit faster than our expectations - and has exposed the index to the 2021 lows (3,664), while sub-3,500 moves will probably need fresh catalyst.

Today however, SPX500 stages a rebound of around 1%, trying to get out of the bear market. This could give it the chance to challenge Monday's gap and reclaim the 3,900 region, but sustained improvement in sentiment will be required for a rise towards the EMA200 above 4,000.

Caution is needed ahead of Wednesday's Fed decision, which has the potential to cause increased volatility and produce outsized moves, especially after the recent repricing in market expectations.