S&P 500 to Stay Bid as Fed Decouples Taper, Rate Hike Risk

STOCK MARKET OUTLOOK: S&P 500 HINGES ON PROLONGED FED ACCOMMODATION

• S&P 500, Nasdaq, Dow Jones surging in the wake of Fed Chair Powell’s Jackson Hole speech
• Major stock indices could keep climbing higher if FOMC officials stay highly accommodative
• Equity investors rejoice as Fed’s Powell signals the decoupling of QE taper from rate liftoff

Stocks seem to be reacting favorably to the latest commentary from Federal Reserve Chair Jerome Powell during his annual Jackson Hole Symposium speech. In fact, both the S&P 500 Index and Nasdaq Composite leapt about 1% on the session to close at fresh all-time highs as the VIX ‘fear-gauge’ plummeted. Stock market gains likely follow the absence of a Fed taper announcement from Powell.

To be fair, though, there was a relatively more hawkish shift in tone from Chair Powell and other FOMC officials. Fed Chair Powell acknowledged that substantial further progress has been made toward reaching the central bank’s price stability mandate and how recent nonfarm payrolls data brought more evidence of progress on the labor market front.

CHART OF FEDERAL RESERVE TOTAL ASSETS WITH EFFECTIVE FED FUNDS RATE OVERLAID

Powell even stated that it could be appropriate to start tapering asset purchases this year if the economy continued to evolve broadly as expected. Nevertheless, stocks were little fazed by this language as investor focus was instead placed on Powell’s vow to continue supporting highly accommodative financial conditions. The Fed Chair noted, for example, how responding to inflation pressures preemptively may do more harm than good, adding that last year’s policy framework shift to average inflation targeting is “well suited” in the current environment.

Furthermore, and perhaps more importantly, Powell pledged to hold the target federal funds rate near zero until the economy reaches full employment. Specifically, Powell outlined how the “timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff.” This decoupling of the start to tapering QE and the expected timing for raising benchmark interest rates likely explains the bullish reaction by equities to Powell’s Jackson Hole Symposium speech.

S&P 500 PRICE CHART WITH VIX INDEX OVERLAID: DAILY TIME FRAME (DEC 2019 TO AUG 2021)

Chart by @RichDvorakFX created using TradingView

S&P 500 price action thus looks poised to continue extending higher in light of this development. That said, it may be prudent for investors to be on alert for a potential stock market correction in the medium-term. This is largely considering the risk of the Fed normalizing more aggressively than expected. After all, abundance of liquidity following the Fed’s unprecedented QE package announced in March 2020 stands out as one of the primary drivers behind higher stock market valuations.

Given the decoupling of tapering asset purchases from raising interest rates, however, it seems plausible to expect that the ‘buy-the-dip’ mentality of investors will persist and keep the S&P 500 afloat more broadly. This is, of course, contingent on the quite likely scenario of prolonged and still substantial Fed accommodation even after the central bank’s balance sheet starts decelerating. The overarching threat for stocks is, nevertheless, red-hot inflation lingering well into 2022 and the labor market bouncing back to full employment faster than what is outlined in FOMC projections.

— Written by Rich Dvorak, Analyst for DailyFX.com

Connect with @RichDvorakFX on Twitter for real-time market insight