Posted 9:30 AM ET – This week we learned that inflation is rising at a steady pace. Market analysts and the Fed are no longer calling this “transitory”. Even the most conservative projections are calling for a 3.5% inflation rate in 2022. The market has shrugged off the news and stocks are within striking distance of the all-time high.
As much as they would like to think that they are in control, the Fed’s hand will be forced. Institutions will start selling bonds before tightening happens. This will pave the way for a rate hike.
Why should we care? From a trading standpoint, the market reaction to the first rate hike is typically negative. Asset Managers reduce risk in the event that rising rates stifle economic growth. When the dust settles a few months later and economic growth remains intact, they reenter the market. Some of the biggest market gains in the last 50 years have come in a rising interest rate environment. Short-term traders need to be mindful that a market drop could be coming.
What happens if rising interest rates lead to economic contraction? I believe this is a legitimate concern. Economic growth has been sluggish globally. US growth is strong, but that is not the case for the rest of the world. Supply disruptions are creating inflation and the rising prices are not demand driven. Rising interest rates are not good for the market if they are not accompanied by economic growth.
Why is the market rallying on the news? As real yields continue to go farther into negative territory (interest rates less inflation), stocks become attractive on a relative basis. Asset Managers believe that corporations will be able to raise prices and to maintain profit margins. Cash will lose purchasing power as inflation takes root so stocks are the place to be.
Can inflation lead to an economic contraction? I believe it can. As interest rates increase the burden on credit card debt increases. Consumers are paying more to finance loans so they have to reduce purchases. Global sovereign debt is skyrocketing. A 2% interest rate increase will cost US taxpayers an additional $600 billion a year on $30 trillion of debt. Government spending will be trimmed to balance budgets.
How does that affect our trading today? The market is in an uptrend and seasonal strength will keep buyers engaged. Dips will be shallow and brief. Until there are signs of a credit crisis, the market will not have a sustained decline.
Swing traders are long IWM. Small-cap stocks are breaking out and we will use a stop of $233 on a closing basis (check price 5 minutes before the closing bell). This is a good time to sell out of the money bullish put spreads on strong stocks. Stock valuations are at levels that we haven’t seen since the 2000 tech bubble so this is as aggressive as I want to get with longer-term swing trades.
Day traders should not chase gaps up. This is our worst trading scenario and you need to wait for a dip or a compression. Given the “soft” price action we’ve seen in the last few days I believe that the bid will be tested today. A compression or a dip will provide us with valuable time to identify relative strength. As always look for stocks with technical breakouts on heavy volume. A “gap and go” rally (unlikely) won’t give us the time we need to find good trades. We’ve seen two-sided price action the last few days and I believe we will see it today as well. Be patient and wait for your trades to set up. The bond market is closed so I believe the market will be choppy.
Support is at SPY $462 and resistance is at $467.50 and $470.
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Happy Veterans Day!