The two words that could turn the S&P 500 upside down

Wall Street is jittery ahead of Federal Reserve Chairman Jerome Powell’s big speech in Jackson Hole, Wyo., on Friday. The S&P 500’s rally is under pressure alongside a shift in yields that favors another 75 basis point rate hike on September 21.




X



But what is there really to fear from Powell’s speech? After all, the Fed chairman suspended forward guidance at his July 27 press conference. This makes it doubtful that he will take a position on the size of the next rate hike.

The worry is that Powell will try to undo the casual impression he gave with his July 27 press conference. Those comments helped the S&P 500 rally as much as 18% from its June 16 closing low, snapping out of a bear market.

However, Powell will stick to his optimistic view that the Fed still has a chance to engineer a relatively soft landing for the US economy. And while policymakers may not be wild about the stock market rally, which works against their efforts to cool the economy and lower inflation, Powell is too wise to target stock prices directly.

So what could Powell say that could upset the S&P 500? Those two words: “The 1970s.”

Federal Reserve History Lesson

In a remarkable speech on March 21, Powell trotted out the Fed’s history of soft landings to support his claim that the current tightening could produce a similar effect. Powell pointed to 1965, 1984 and 1994 as evidence that Fed tightening need not lead to a recession.

He also cited Federal Reserve tightening from 2015 to 2019 to bolster his case. And while a recession followed in 2020, Covid — not the Fed — was to blame.


Federal Reserve Meeting Minutes Reducing the odds of a big rate hike


Now some economists think Powell may decide to give a somewhat less refreshing history lesson. Nomura economists Aichi Amemiya and Robert Dent wrote in their Jackson Hole preview that Powell’s speech may have “an emphasis on the experience of the 1970s.”

“Some Fed participants have recently pointed to that time with some level of caution, usually to emphasize their preference to avoid a strict stop-and-go course,” they wrote.

‘Tighter for longer’ Fed?

Except just before the pandemic, the last time unemployment hit 3.5% was in 1969. The Fed responded by raising its key interest rate to 9% to try to short-circuit a period of wage inflation.

However, the Fed reversed course in 1970. It lowered the federal funds rate to less than 4% in early 1971. This helped push the unemployment rate to 6%. But “it was not high enough to ease wage pressures,” Jefferies chief financial economist Aneta Markowska wrote in a June 3 note.

“The Fed has not created enough easing to compress inflation and stabilize inflation expectations,” he wrote. “Policymakers repeated the same mistake in the mid-1970s, hiking aggressively and triggering another recession, but then relaxed too quickly and allowed inflationary pressures to reassert themselves.”

The lesson, in Markowska’s view: “When faced with a feedback loop between prices and wages, the Fed needs to stay tighter for longer.”

“Tighter for longer” is the last message investors want to hear, and a term Powell is unlikely to touch. That’s because the S&P 500’s rally has been built at least in part on the hope that the Fed will stop raising rates in early 2023 and turn to a rate cut around midyear.

Relaxation of economic conditions

Financial markets are already looking for a reversal of Fed tightening. This, in turn, has resulted in easing financial conditions, reflected in lower market interest rates and higher S&P 500, Dow Jones Industrial Average and Nasdaq.

Minutes from the Fed’s July 26-27 meeting highlighted a “significant risk” that “elevated inflation could consolidate if the public begins to question the Commission’s resolve to adequately adjust the policy stance.”

The minutes noted: “If this risk were to materialize, it would complicate the task of returning inflation to 2% and could significantly increase the economic cost of doing so.”


The CPI inflation index is finally coming down — much more than expected


To counter that risk — that the recent easing of financial conditions is keeping inflation higher — Powell may want to instill more doubt that the Fed’s rate-cutting shift will come soon.

This may not bode well for the S&P 500 or the US economy in the short term. But, Nomura economists write, Powell may argue that the Fed’s failures in the 1970s and the Fed’s final “decisive efforts to reduce inflation” under Chairman Paul Volcker show that the short-term pain will be worth it .

Be sure to read IBD’s The Big Picture column after each trading day to get the latest information on the prevailing market trend and what it means for your trading decisions.

Follow Jed Graham on Twitter @IBD_JGraham to cover economic policy and financial markets.

YOU MIGHT ALSO LIKE:

The market is expecting something like this from the Fed’s Powell. 5 New Stock Flash Market Signals

IBD Digital: Unlock IBD’s Premium Stock Lists, Tools and Analysis Today

Because this IBD tool simplifies the search for top stocks

Profits from short-term trading: IBD SwingTrader

Find today’s best growth stocks to watch with the IBD 50

Leave a Reply

Your email address will not be published.