Markets Brace for Fed Testimony

U.S. equity markets were mixed and mostly pressured for much of the trading day on Tuesday until a late-day rally pushed the large-cap S&P 500 and small-cap Russell 2000 into slightly positive territory. The same cannot be said for the Dow Jones Industrial Average, which completed its third down day on Tuesday since hitting its new all-time high last week.

In contrast to the industrials-focused Dow, the tech-heavy Nasdaq Composite was up modestly for most of the day, rising just under a key double top pattern. Earlier on Tuesday, European markets closed in the red following mixed to negative performance from the major Asian indexes.

Recent lackluster market performance across the globe, but especially in the U.S., can be attributed in part to investor caution ahead of key testimony this week by Federal Reserve Chair Jerome Powell in front of the U.S. Congress. Powell will be testifying in front of the House Financial Services Committee on Wednesday and the Senate Banking Committee on Thursday. In the past, such testimony has been known to affect markets due to resulting shifts in interest rate expectations.

Prior to last week’s U.S. jobs report, there had been extremely high market expectations that the Fed would begin implementing interest rate cuts beginning this month as a policy reaction to slowing economic growth, lagging inflation, and potential fallout from trade wars. Although these rate cut expectations remain high, last week’s jobs report showed much stronger employment growth than expected, which created some doubt as to whether the Fed would continue to be so intent on cutting rates.

On top of the jobs report, another factor that may hold the Fed back has been its insistence that the central bank is independent and not subject to influence by President Trump, who is a strong proponent of cutting interest rates. Any defiance by Powell may be interpreted as a sign that the Fed may not be cutting rates as quickly or as substantially as markets may expect.

This week’s testimonies by Powell, along with Wednesday’s FOMC meeting minutes and Thursday’s key U.S. inflation data in the form of the consumer price index (CPI), should set the stage for the stock market’s direction in the near term with respect to interest rates. If expectations lean toward more aggressive rate cutting, stocks may receive a further boost into record-high territory. In contrast, if markets begin to feel more hesitancy from the Fed in terms of rate cuts, equities could pull back further.

The S&P 500 (SPX) chart shows a clear picture of what’s happening with the market at large. The middle of last week saw a new record high for the benchmark index before the current pullback.

However, aside from the fact that the index is near all-time highs, the technicals remain strongly bullish. Long-term and medium-term trends continue to point strongly to the upside, momentum remains bullish, and the current pullback is shallow.

Depending on how markets perceive Powell’s statements and innuendos this week, any sign of a solid path to lower interest rates could prompt an upside breakout for the S&P 500 and equity markets as a whole.

The closely watched 10-Year Treasury Note yield is a primary benchmark for government bond yields, and it is firmly tied to market expectations surrounding the Fed’s setting of the overnight federal funds rate. When Fed rate cuts are expected, yields tend to drop. Now, as those rate cut expectations have eased, especially after last week’s strong jobs report, yields have bounced.

The chart shows the 10-year yield having just rebounded from a low not seen since November 2016. Clearly, the yield has been in an exceptionally strong downtrend since the highs of last October and November. Any resumption of expectations for a brisk pace of rate cuts could see the yield break down to lower lows.

Finally, we have small-cap stocks, as represented by the Russell 2000 (RUT) index. While large caps (as in the S&P 500, Dow, and Nasdaq Composite) are at or very near all-time highs, small caps have lagged. In fact, the Russell 2000 is a full 10% below its own record high from last September.

While RUT has indeed risen around 16% since the lows at the beginning of the year, it hasn’t come close to recovering its massive losses from the latter part of last year like the large-cap indexes have. This may change at some point, but since the Russell 2000 is often seen as a leading indicator for the rest of the market, its relatively weaker performance may be a concern for the larger market.

It’s all (or mostly) about the Fed this week. Investors are bracing for what Powell may say to Congress and how his words will be interpreted. Of course, any new developments in U.S.-China trade talks and the new upcoming earnings season will also be pivotal. But interest rate expectations will likely set the primary direction for markets in the near term.

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