Rally Hesitates on Higher Inflation

U.S. stocks started out early Thursday in highly bullish mode on the heels of Fed Chair Jerome Powell’s dovish congressional testimony a day earlier. But that initial rally was tempered by key inflation data released on Thursday morning that showed U.S. consumer inflation in June having increased by the most in well more than a year. As the trading day wore on, and even after Powell’s second day of testimony (this time in front of the Senate), stocks dipped in and out of the red.

The core consumer price index (CPI), which excludes food and energy, came out at +0.3% for June against previous consensus expectations for +0.2%. Such an increase in core consumer inflation has not occurred since January 2018.

Why is higher-than-expected inflation important for stocks? One of the key reasons the Fed is considering cutting interest rates in July and beyond is due to “muted inflation.” But if inflation is seen to be picking up, the Fed may opt to cut rates less aggressively, perhaps with smaller rate cuts than might otherwise be expected.

In turn, if there’s a slimmer chance of heavy rate cuts, investors would typically be less inclined to continue buying up and boosting stocks. Generally speaking, lower interest rate environments often result in higher stock prices, as declining rates help increase spending and decrease borrowing costs for companies.

As it turns out, stocks sputtered somewhat in afternoon trading on Thursday and then closed mixed for the day after Wednesday’s rally. But the damage wasn’t severe, as investors still expect a 100% probability of a rate cut later this month. But what has changed after the inflation report, according to the CME Group’s FedWatch tool, is that there are now significantly fewer bets on a larger (50-basis-point) interest rate cut than on Wednesday.

As shown below on the 10-year U.S. Treasury yield, a primary benchmark for bond yields, the higher inflation numbers on Thursday helped prompt a further rebound for yields off the multi-year low hit early this month.

As we noted on Tuesday, small-cap stocks have had a hard time keeping up with their large-cap counterparts. This is a potential warning signal for the entire market, as small caps are often seen as a leading indicator for the rest of the market.

On Thursday, the major small-cap benchmark, the Russell 2000 (RUT), was deep in the red in comparison to the major large-cap indexes (the S&P 500, Dow, and Nasdaq Composite). But it hasn’t just been on Thursday. Small caps have lagged considerably since late last year. The Russell 2000 is now more than 10% below its record high from last August. In contrast, the large-cap indexes are currently at or just off new all-time highs.

Small caps’ relatively weaker performance may be a concern for the larger market. As shown on the chart, RUT has been trading in a progressively tightening consolidation. This suggests a potential breakout on the horizon. If that breakout is to the downside, there may be even more trouble in store for the rest of the market.

Brazilian equities have been on a remarkable run since May. This has occurred despite negative economic growth that places the country on the verge of a recession. Helping to boost Brazilian stocks, though, have been both a broad-based effort to reform Brazil’s pension system as well as expectations that the central bank will cut interest rates from current record lows.

As shown on the chart, the iShares MSCI Brazil ETF (EWZ) has risen by more than 26% since mid-May. At this point, however, price has reached up to a major resistance area around the January 2018 highs. Also, technical indicators have been flashing overbought signals. In itself, this does not necessarily signify a potential reversal. Indeed, if there’s a confirmed breakout above resistance, that would be a significantly bullish sign. But caution around this area should be exercised, as sellers tend to congregate around key resistance areas.

The CBOE Volatility Index (VIX), or the “fear gauge,” is a real-time market index representing the market’s expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear, or stress in the markets when making investment decisions. Generally speaking, when equity markets fall and investors become worried, the VIX tends to rise. And when markets rise as investors are less concerned and have a greater risk appetite, the VIX tends to fall.

As shown on the chart, investors currently seem quite unconcerned. At around 12.93, the VIX is not far above the lows of this year, and it is well below the 50-day and 200-day averages. While this may suggest that all is fine, at least from the market’s perspective, significantly higher volatility has a way of following exceptionally low volatility. This may turn out to be one of those times.

Fed testimony is out of the way, and it looks like we’ll likely get a rate cut at the next FOMC meeting on July 31. How big that cut may be remains to be seen, and it could be affected in part by the higher inflation seen today in the core CPI. The producer price index (PPI), a less-followed inflation indicator, will also be released on Friday morning.

Aside from that, it’s all about the new earnings season starting next week. The commercial banks will lead the way. For the markets, earnings will take center stage in the next few weeks, at least until the crucial Fed meeting at the end of this month.

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