Rude Awakening

The market has a severe disbelief in the Fed's resolve to fight inflation. Based on recent market action, the majority of investors believe the Fed will pivot away from fighting inflation toward supporting the weakening economy. However, the higher than expected CPI number released this morning jolted said majority into reality.

Until this morning's CPI number, there had not been a widespread belief that the Fed would remain aggressive in fighting inflation at the expense of the economy. The consensus that the Fed was more focused on economic growth, despite their consistent narrative, has kept buyers coming back in whenever there’s a minor selloff.

Last week, the market bounced right off the 3900 level we had highlighted, helped by the 50-day moving average crossing above the 100-day moving average. If the market somehow shakes off this morning's startling inflation level there is a chance the S&P 500 could move towards the 200-day moving average around 4270. However, given the adverse reaction to the CPI release, we don't see that being likely.

There is also growing belief that the Fed will leave their balance sheet untouched and not contract at a rate of $95B a month as they have declared. We believe three things to be true:

1. Balance sheet reduction will have the largest impact on the stock market, as the excess supply of liquidity has been the main driver of stock price returns
2. If the Fed does what they say they will and liquidity dries up, the market could correct substantially
3. The Fed will be true to their word and actually reduce the balance sheet

Given our stance, we recommend a cautious investment approach. On top of that, volatility may be heightened by the fact that we are currently in the information doldrums of the Fed blackout period. We will not be hearing from any central bankers until they meet at the FOMC next week, removing the opportunity for them to placate investor fears.

Best,

Pave Team