Fed Outlook Divides U.S. Stocks: Tech Rally's Limit?

Last week, the U.S. stock market showed a mixed performance, influenced heavily by the Federal Reserve’s recent decision to maintain interest rates. This marked the seventh consecutive meeting in which interest rates were held steady. Central to these discussions was the release of the quarterly economic outlook (SEP), where the Fed revised its expectations surrounding core inflation and interest rates. Originally projecting three rate cuts by the end of the year, this forecast has now been scaled back to just one. Jerome Powell, the Fed chair, expressed cautious optimism during a press conference, indicating that recent inflation trends were cooling but emphasized that further evidence is necessary before they can confidently predict a return to a sustainable 2% inflation rate.

A noteworthy series of data releases this past week aligned with the Fed's hopes for a more stable economic outlook. In May, the Consumer Price Index (CPI) unexpectedly remained unchanged, reaching its lowest point since July 2022. This decreasing trend in CPI has been evident since March. Additionally, the Producer Price Index (PPI), which tracks upstream costs, decreased by 0.2%, marking the lowest level in the past six months. Notably, the services sector, previously a significant source of inflationary pressure, saw its cost figures drop to zero, excluding energy.

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Bob Schwartz, a senior economist at Oxford Economics, highlighted the encouraging CPI data during an interview, expressing that such signs of persistent anti-inflation progress would likely be welcomed by the Fed. However, he cautioned that after the earlier adverse inflation reports earlier in the year, convincing evidence is still vital to support the Fed's target inflation levels.

Meanwhile, the labor market appears to be losing steam, as indicated by last week's initial unemployment claims rising to a ten-month high of 242,000. This trend aligns with decreasing job openings as revealed in the JOLTS report and recent dips in ADP employment figures.

Investor sentiments regarding a shift in monetary policy have intensified. Long-term Treasury yields experienced a significant decline, with the two-year Treasury note dropping by a noteworthy 18.6 basis points to 4.68%, marking its largest drop in five weeks. Similarly, the benchmark ten-year Treasury yield fell by 21.6 basis points to 4.21%. According to the Chicago Mercantile Exchange’s FedWatch tool, there is 61% probability of a 25-basis point rate cut by the Fed in September, with expectations of at least two cuts by December now exceeding 70%.

Divergence exists among institutions regarding the timing of potential rate cuts, with UBS global research suggesting that a rate cut might not occur until December, contrasting with predictions from Goldman Sachs and Morgan Stanley, who maintain that the first cut will take place in September.

Schwartz reiterated the importance of data in guiding the Fed’s policy decisions, referencing Powell’s earlier comments that a stable labor market empowers the Fed to focus more intently on inflation in its decision-making process. He asserted that the Fed will require several months of low inflation data before feeling confident enough to consider rate cuts. Nevertheless, he noted that a September rate cut remains a significant possibility.

Turning to market momentum, the prevailing optimism surrounding a potential easing of Fed policy, combined with strong performances in the tech sector, led to the S&P 500 and Nasdaq posting gains for the seventh consecutive week. The tech space has firmly positioned itself at the forefront of current market dynamics, particularly with the continued emergence of artificial intelligence (AI). Apple's recent affirmations of its leading market position and the unveiling of new AI capabilities at its Worldwide Developers Conference have sparked enthusiasm amid speculations of a surge in device upgrades. Tech giants Microsoft and Nvidia have also performed robustly, with their market capitalizations surpassing the $3 trillion mark.

Despite the optimism, concerns remain regarding the pace of economic slowdown under the Fed's policies—evidently reflected in the Dow Jones Industrial Average and the Russell 2000 index, which showed declines last week. An increasing nervousness regarding the Federal Reserve's policy trajectory has led to substantial fund outflows from U.S. stock funds, with recent data from the London Stock Exchange Group suggesting net redemptions of $21.93 billion last week, the largest outflow in 18 months, leaving the tech sector as the only area seeing net inflows. Amidst a flight to safety, money market funds attracted $20 billion, reaching a new historical peak in total size.

Charles Schwab noted in their market outlook that the rise in U.S. stock prices was primarily driven by lower-than-expected inflation data combined with a corresponding decline of 20 basis points in both the 10-year and 2-year Treasury yields. However, they cautioned that developments are not solely dovish as the Fed's dot plot indicates that rate cuts are unlikely to be frequent—projecting only one cut. In essence, a significant part of the S&P 500's 14% rally this year can be attributed to the performance of large-cap tech stocks, while equal-weight indices like the S&P noted only a 3.2% increase so far.

Looking ahead to the upcoming week, several factors raise concerns. Technically, the market appears overbought, especially within tech, and with Nvidia’s split and Apple’s recent events, there seems to be a lack of immediate catalysts likely to sustain momentum (save for Micron's forthcoming earnings report and May’s PCE data scheduled for release in two weeks). Thus, the risk-reward balance could begin to shift back toward consolidation, hinging upon the tech sector’s ability to maintain consistent buying momentum.