Why Wall Street's next move depends on the Fed

U.S. equities have been on a run that has pushed the Dow Jones industrials index over the 18,000 threshold in recent weeks for the first time since last summer, moving the benchmark to within a few hundred points of a new record high. That's despite a batch of poor earnings news and underperformance by big-cap tech stocks.

Overall, first-quarter 2016 earnings for S&P 500 companies are forecast to drop 8.9 percent, which would mark the fourth consecutive quarter of falling profitability and represent the worse result since 2009.

Yet all eyes are on the upcoming Federal Reserve monetary policy announcement on April 27. The stakes are high -- as they often are with Fed decisions -- with Fed Chair Janet Yellen facing pressure from all sides. If stocks are to surge higher from here, it will depend on Yellen giving the market what it wants: No rate hikes for the foreseeable future. At least, not until this autumn, based on futures market pricing.

One gets the feeling that the next move in stocks will be 10 percent in either direction hinging on the Fed's decision and whether it teases a June rate hike.

Clearly, the market response to the December rate hike, the first since 2006, didn't go as planned as the Dow industrials lost more than 13 percent in the following weeks.

Since then, the Fed has aggressively walked back its rate hike expectations for the year: From four 0.25 percent hikes in December to just two now, which is closer to the futures market forecast for a "one and done" rate hike late this year.

If the Fed is going to stick to its two-hike forecast, April will need to open the door to action in June given ongoing tightening in the labor market and a firming of core inflation. Energy prices have been a big drag on inflation but have recently stabilized. If crude oil holds near current levels above the $40-a-barrel threshold, energy prices will become a net contributor to higher inflation in less than four months.

Another factor is the presidential election. To avoid the perception of influencing voters, the Fed will want to make any moves now, go quiet during the summer and early fall, and become active again at the end of the year. This suggests a move in June and again in December.

Unfortunately, stocks don't seem ready to tolerate another increase in interest rates. Technical and fundamental headwinds remain.

Friday's flash purchasing managers index of manufacturing activity dropped to 50.8 vs. expectations for a 52 result and a prior month reading of 51.4. Overall, the Bloomberg U.S. Macroeconomic Surprise Index -- measuring how the data is coming in vs. expectations -- has dropped to 14-month lows. The Atlanta Fed's GDPNow tracking estimate of first-quarter U.S. GDP growth is just 0.3 percent.

Technically, U.S. equities are contending with massive overhead resistance from a "topping pattern" that started back in 2014 amid narrowing breadth. With stocks from Apple (AAPL) to Amazon (AMZN) rolling over, fewer and fewer names are holding the major averages aloft. Apple will report results on April 26, and it's expected to show its first year-over-year decline in earnings since 2013 as iPhone sales slow.

Historically, according to Michael Hartnett at Bank of America Merrill Lynch, a hike-pause-hike cycle has resulted in poor stock market returns. In the five occasions of this since 1926, large-cap stocks were down an average of 1.2 percent six months later and up just 3.1 percent 12 months later.

A "one and done" tightening cycle -- in which the Fed hikes and then is forced to cut rates in an admission of a policy mistake -- has been much better for stocks: In the seven times this has happened, stocks gained an average of 1.2 percent six months later and a whopping 18.5 percent 12 months later.

Yet BofA Merrill Lynch economists are looking for the Fed to make two rate hikes this year, either in June or July and again later this year, based on job market progress, inflation stability and calmer financial markets. The first hint of this would be small changes in the policy statement wording -- simply noting the global economic and financial risks have moderated.

The irony: An expression of increased confidence in the economic outlook from the Fed could be exactly what Wall Street fears the most.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.