That was not pretty, but it was long overdue. The Fed moved in a slightly more hawkish direction than some anticipated, going from an expected four rate cuts in 2025 to two or less. The news was not earth shattering. Much of the market already was anticipating only two or three rate cuts, so the magnitude of the moves (in stocks, the dollar, and bond yields) caught many by surprise. The CBOE Volatility Index put in a rare one-day move of 60%, from 15 to 27, a level it hasn’t seen since a brief panic in August. .VIX YTD mountain CBOE Volatility Index, YTD The market response was surprising only because positioning in the stock market had become so extreme. Stocks catching up with bonds What seems to be happening is this: the stock market is catching up with the bond market. Bond vigilantes have been signaling concerns over several areas: 1) inflation, 2) deficits and 3) tariffs and 4) tax cuts. The stock market has ignored most of this. Inflation, while coming down, is still not at the Fed’s target of 2% a year. Interest rates have recently begun to trend upward, which is unusual given the Fed has been cutting short term interest rates. US10Y YTD mountain U.S. 10-year Treasury yield, YTD On CNBC Wednesday, Jeff Gundlach noted that the Fed has cut interest rates 100 basis points (1 percentage point) since September and yet the 10-year Treasury yield is up over 80 basis points since then, implying the bond market still has concerns about inflation. Powell seemed to also reflect these concerns. “It’s appropriate to move cautiously, and look for progress on inflation,” he said at his press conference after the Fed policy meeting wrapped up. For others, the Trump agenda of rate cuts and tariffs is also seen as inflationary. A report out Wednesday from the Congressional Budget Office noted that tariffs might help reduce the deficit, but may also cut growth and raise inflation. Powell noted that tariffs introduced uncertainty into the inflation outlook. Gundlach also took the opportunity to highlight the higher deficit as a factor for 2025 interest rates. “The interest expense on the debt is going to be really problematic,” the money manager said. “I think that has something to do with the market sussing out that we have an interest rate problem. We used to pay $300 billion in interest expense [annually] and now it’s $1.3 trillion in interest expense.” The implication: if interest rates go higher the government will be forced to spend more to service the debt. The stock market has largely ignored these concerns. Since the Fed began cutting rates in September, the S & P 500 is up about 8%. “The market is clearly overbought,” Gundlach said. December was already weird The market had been showing signs of stress even before the Fed meeting. .SPX 1M mountain S & P 500, 1-month Market watchers had been noting that the S & P 500 was basically flat this month, but breadth (stocks advancing versus declining) was poor and there was an unusually high degree of dispersion. What’s dispersion? In plain English, mega cap tech was strong, and most everything else had been weaker. While megacap tech saw an outsized drop Wednesday, the broader trend (megacap tech up, everything else weaker) was still evident. S & P tech leaders in December Broadcom up 40.0% Tesla up 27.5% Alphabet up 11.5% Amazon up 6.1% Micron up 6.1% Apple up 4.5% Meta up 4.0% Microsoft up 3.3% S & P sector laggards in December Energy down 11.6% Banks down 10.6% Materials down 9.9% Real Estate down 9.8% Utilities down 9.8% Industrials down 8.0% Health Care down 6.9% Next up: PCE For bulls, there are three talking points: 1) the initial reaction to a Fed meeting is often wrong, 2) we are entering the final two weeks of the year, one of the strongest two-week periods of the year and 3) the inflation data may improve. The last talking point may be the best hope for a short-term rally. The Fed’s preferred inflation gauge, Personal Consumption Expenditures (PCE), will be out on Friday. If PCE in November was much higher than anticipated, that will add fuel to the selloff. If it is lower, than stocks will likely rebound. Bulls can also take solace in the economy. Powell said that the U.S. economy was strong and he was optimistic about the economy in 2025. If only he had more control over the interest rates that are set in the open market.
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