US Stocks Rally Into Higher Yield Headwinds

Chart, Trading, Courses, Forex, Analysis

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Despite facing headwinds from higher US yields, Wall Street's main indexes made gains on Monday. Mega-cap growth stocks, including Alphabet (GOOG) and Tesla (TSLA), supported the rebound, which helped lift the technology-heavy Nasdaq.

Investors are currently focusing on the Federal Reserve's upcoming meeting, where they hope that the Fed will successfully thread the needle through a mixed bag of data and keep the rally rolling. Still, traders are grappling with a competing narrative. On one hand, there is enthusiasm surrounding the potential of artificial intelligence (AI) and its impact on the technology sector. On the other, there is palpable apprehension ahead of the Federal Reserve's statement and commentary expected on Wednesday. This balancing act reflects the broader uncertainty as investors weigh the bullish impulse from the transformative potential of AI against the backdrop of evolving monetary policy and its implications for asset prices.

The crux of the matter lies in the Federal Reserve's assessment of recent inflation overshoots in January and February. If the Fed interprets these overshoots as indicative of a rekindled price growth impulse, it may adjust its projections accordingly. This could result in the new dot plot reflecting only two rate cuts in 2024. Conversely, if the Fed views the inflation overshoots as seasonal, the dot plot might still show three rate cuts

The market reaction hinges on this distinction. If the dot plot indicates two rate cuts, stocks will flinch. Suppose three rate cuts remain for the year, and the core Personal Consumption Expenditures (PCE) projection stays relatively unchanged compared to December's Summary of Economic Projections (SEP). In that case, there may not be a clear reason for equities to react negatively. This doesn't imply smooth sailing ahead; it simply emphasizes that this week's key focus for the short-term market sentiment lies in the median 2024 dot and, closely related, the 2024 core Personal Consumption Expenditures (PCE) projection. These indicators will provide crucial insights into the Federal Reserve's outlook and potential future policy actions, shaping market reactions accordingly.

There's no denying the significance of the dot plot's implications, and it’s a squeaker. A closer look at the dispersion of the dots reveals that just two participants shifting from projecting three cuts to two would be sufficient for the median dot to move to a total of two cuts for the year.

This scenario poses the main downside risk for stocks, as it could further encourage the US rate market to scale back expectations for Federal Reserve rate cuts. Any indication from the FOMC meeting that supports a less dovish stance than previously anticipated could lead to a reassessment of rate cut expectations, sending yields soaring and stocks tanking.

Perplexing Dynamics

In stark contrast to the exuberant "everything rally" witnessed in November and December, which was largely fueled by the prospect of significantly easier monetary policy in 2024, this year's surge in risk assets has unfolded against a backdrop of diminishing rate-cut expectations. Among the myriad of perplexing dynamics confounding market participants in their quest for clarity in 2024, perhaps none is more stupifying than the disconnect between equities and rate-cut expectations.

The most digestible explanation for this detachment is that while rate-cut expectations have halved, that is due to the US economy exceeding forecasts, which is positive for stocks. At the same time, the Fed is still likely to cut rates this year, but perhaps not as aggressively. Still, a sturdy economy plus rate cuts is the best possible scenario, and it’s fair to suggest that it’s now the consensus.

And when you factor in the generational secular phenomenon of AI, along with the associated higher earnings revisions, it is reshaping the landscape for index heavyweights. Companies operating in the AI sector are surpassing previous sales, earnings per share (EPS), and guidance expectations almost every quarter, creating a halo effect that reverberates across global markets.

Therefore, a pivotal question that arises this week is whether the trajectory of interest rates will begin to carry greater significance for the valuations of large-cap equities.

OIL MARKETS

Oil prices surged to a four-month high on Monday, propelled by a combination of bullish macroeconomic data from China and heightened geopolitical tensions stemming from a fresh wave of Ukrainian drone attacks targeting Russian energy infrastructure.

The positive macroeconomic data from China indicated a rebound in industrial production at the beginning of the year, signalling an improving demand outlook for oil. Meanwhile, the Ukrainian drone attacks on Russian energy infrastructure added to supply concerns, further supporting the upward momentum in oil prices.

These factors combined to drive oil prices to their highest levels in four months, underscoring the intricate interplay between economic indicators and geopolitical events in shaping commodity markets.


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