Rally Stumbles on Fed Concerns

Stock and bond prices fell on Thursday as forecasts of a more aggressive Fed rate hike declined. This decrease in Fed expectations was driven by a couple of factors, most notably the European Central Bank’s (ECB) rate decision early on Thursday.

The ECB left interest rates unchanged, as widely expected, and also indicated the potential for a rate cut some time this year. However, ECB President Mario Draghi downplayed the need for more drastic easing measures by saying that the risk of recession in Europe is “pretty low.” This language was somewhat of a surprise to analysts and economists who were expecting a more dovish approach. The resulting speculation that the Fed may also be less dovish than expected at next week’s FOMC meeting pressured stocks and bonds.

Contributing to this pressure on Thursday was a U.S. data release on durable goods orders for June that was substantially better than expected. Although this release is not the most widely followed of economic data points, it adds to the recent spate of data that suggests a healthier U.S. economy than previously thought.

In turn, this raises doubts as to whether the Fed is really justified in cutting interest rates. One of the main factors driving stocks and bonds to new highs recently has been increasing expectations of more aggressive Fed cuts. Without that impetus, the rally has less of a reason to continue.

Again, we turn to the CME Group’s FedWatch tool, which shows market-driven expectations of Fed interest rate changes. Though there is still a 100% probability of any Fed rate cut at all, the chances of a smaller 25-basis-point cut have risen, while the expectations of a larger 50-basis-point cut have decreased markedly.

The market impact of this change in Fed expectations was clear. The major stock indexes were all significantly in the red on Thursday, and bond prices also fell as bond yields rose on the prospect of potentially less aggressive rate cuts from the Fed (bond yields and prices are inversely correlated).

Below, we have a chart of the iShares 20+ Year Treasury Bond ETF (TLT), which shows Thursday’s drop back down to touch the key 50-day moving average. This puts the ETF at a critical price juncture. TLT is still entrenched in a strong uptrend, but if the Fed indeed becomes less dovish on cutting interest rates, we could be seeing a possible breakdown below the moving average and a potential downturn for bonds.

It was a bad day for markets overall, but it was especially bad for Tesla, Inc. (TSLA), which posted a worse-than-expected loss and weaker-than-expected automotive gross margins a day earlier. Shares of Tesla dropped a full 14.30% on Thursday, making it among the biggest losers of the day.

The troubled company has seen its stock fall dramatically since late last year, even as the market as a whole has rallied sharply. Since early June, the stock has been on the rebound, climbing above both its 50-day moving average and a key support/resistance level around $250.00. Thursday’s drop, however, puts the stock well below that level and approaching its 50-day average to the downside once again. With any follow-through on the sharp stock decline, a key bearish target is around early-June’s $177.00-area low.

As noted, the ECB decision and announcement on Thursday was generally less dovish than expected. Interest rates are directly related to currencies. Just as Fed moves and expectations are tied closely with the U.S. dollar, ECB moves have an impact on how the euro currency rises or falls. Immediately after the ECB announcement, which downplayed aggressive rate cuts, the euro rose as might have been expected. It then settled back down as the dollar strengthened.

As shown on the chart of the EUR/USD (euro against the U.S. dollar), the euro is near a two-plus-year low against the U.S. dollar. In fact, the euro is exceptionally weak against most of its counterparts. As for EUR/USD, the currency pair has settled around the key 1.1100 support. While this support should hold for the time being, if there is any breakdown on a weaker euro or stronger dollar, the next key target to the downside is around the 1.0900 support level.

Though we’re not expecting any dramatic pullbacks for equity markets on the horizon, there could likely be some turbulence in the short-term as markets sort out their Fed expectations, and especially when the FOMC meets mid-week next week.

Earnings results remain better-than-expected overall, and U.S.-China trade meetings are expected to resume once again next week. These are both potentially market supportive. The biggest unknown remains with the Fed. What markets expect it to do and what it actually does will most likely be the major market mover for at least the next four trading days.

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