foxex: Can Lower Interest Rates Save the S&P 500?

Chart Advisor | Focus on the Price

Tuesday, May 28, 2019

1. TNX drops to 52-week low

2. S&P 500 completes bearish reversal pattern

3. Traders pricing in late-2018 interest-rate cut

Major Moves

The 10-year Treasury Yield (TNX) dropped to a new 52-week low today as traders moved more money out of riskier stocks and into the safety of Treasuries.

This isn't a new trend for the TNX, but based on the previous pullbacks in the index, I'm starting to wonder if we may be nearing a support bounce up off the down-trending support level that has been interacting with the TNX during the 2019 calendar year.

The last time the TNX dropped down like this, it rallied at support in late-March, just like it did the time before in early-January. Perhaps 2.25% could be the next rally point.

Long-term Treasury yields can have a dramatic impact on the health of the U.S. economy. When they rise too high, they can limit growth because they make it too expensive to borrow money. Conversely, when the fall too low, they can encourage growth because they make it incredibly cheap to borrow money.

If we can avoid further negative economic shocks from the trade war between the United States and China, these falling longer-term Treasury yields could spur growth in business development, the housing market and the share buyback programs at many Fortune 500 companies.

It's too early to tell, but falling interest rates may be just what the doctor ordered for the bulls on Wall Street.

S&P 500

I've been watching and waiting for a week to see if the S&P 500 was going to catch a bullish break and rebound up off support or break down through support and complete a bearish head-and-shoulders reversal pattern.

Unfortunately for all the stock market bulls out there, the S&P 500 completed its head-and-shoulders pattern today.

The bearish break wasn't a dramatic one. The index didn't close too far below support, but it did break through. Plus, with the S&P 500 barely closing above its low for the day, we know there wasn't a lot of bullish momentum coming into the closing bell.

Plus, the S&P 500 closed below the key support level of 2,816.94 that it established on October 17, 2018, which indicates we could be in for more profit taking.

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Risk Indicators - CME FedWatch

One of the primary drivers of the bull market on Wall Street during the past decade was the accommodative monetary policy of the Federal Open Market Committee (FOMC). The FOMC not only kept interest rates at virtually 0% from late-2008 through late-2015 but also injected billions of dollars into the economy by buying U.S. Treasuries and mortgage-backed securities.

While most analysts anticipate the FOMC is done buying assets in the near term, many are starting to price in the possibility the FOMC may start cutting interest rates again.

Currently, the target range for the Federal Funds rate – the short-term interest rate the FOMC tries to control – is 2.25% to 2.50%. Sometimes you will see this written as 225-250 basis points (bps).

The FOMC set this target range at its monetary policy meeting in December 2018. However, at that same meeting, the FOMC signaled that it was done raising interest rates for a while because it felt that inflationary pressure was no longer a threat and it didn't want to risk stifling economic growth.

Typically, the FOMC will lower interest rates to stimulate the economy – because lower interest rates make it easier for businesses and individuals to finance growth through borrowing. Conversely, the FOMC will raise interest rates to combat inflation – because higher interest rates make it more difficult to for businesses and individuals to borrow, increase the money supply and drive prices higher.

Interestingly, even though the U.S. economy is currently showing strong numbers, an increasing number of traders is starting to anticipate the FOMC is going to start lowering interest rates again by the end of the year to combat potential recessionary pressures in 2020 and beyond.

You can see this by looking at the Chicago Mercantile Exchange (CME)'s FedWatch tool, which tracks trader sentiment toward the FOMC.

Looking at the FedWatch tool estimates for the December 2019 FOMC monetary policy meeting in the chart below, you can see that traders estimate there is only a 24% chance the FOMC will leave the Federal Funds rate at its current range of 225-250 basis points past December.

Traders are pricing in a 41.8% chance the FOMC will cut rates by 25 basis points (to a range of 200-225 bps) and a 26.2% chance the FOMC will cut rates by 50 basis points (to a range of 175-200 bps).

All told, traders are currently pricing in a 76% chance of an interest-rate cut before the end of the year. To put this in perspective, traders were only pricing in a 65% chance of a rate cut one month ago.

If they are correct, and the FOMC is going to cut rates, we have to imagine that the FOMC is going to be doing so in reaction to a slowdown in economic growth.

I'm going to be watching these numbers closely. If traders continue to price in an increasingly greater chance of a rate cut by the end of the year, we have to imagine those same traders the chance of a pullback in the stock market is also increasing.

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Bottom Line - Clouds are Forming

The S&P 500 took a turn for the worse today by completing its bearish head-and-shoulders reversal pattern, but that doesn't mean it can't recover. The bearish clouds are forming but the thunderstorm hasn't started just yet.

Lower interest rates may provide a bullish boost if they have time to play out before we get any more negative economic or geopolitical news.

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