After Monday's relief rally, attention shifts to earnings and policy fronts

With the easing of tensions in the Middle East, safe-haven demand reversed course; global stock markets experienced a modicum of relief. Indeed, in a classic relief rally fashion, Monday saw a rebound in the S&P 500, snapping a six-day losing streak. Yet, investors remain highly cautious on both the earnings and policy fronts.

The nature of the soft rebound, whether it's a dead cat bounce, a short-covering rally, or the beginning of a more promising trend, hinges largely on how investors interpret the earnings landscape and in which direction US economic data unfolds in the coming days.

With a high bar set for expectations, investors are now paying attention to the upcoming Big Tech earnings reports. Meta (META), Microsoft (MSFT), and Alphabet (GOOG) are among the major companies scheduled to release quarterly reports, and their performance is expected to influence the short-term market dynamics significantly.

The recent downturn in the stock market seems primarily linked to the uncertainty surrounding the timing of Federal Reserve easing, driven by the evolving inflation landscape, rather than any significant deterioration in the overall earnings outlook. However, with “higher for longer” come the valuation compressions as it becomes more challenging to pull forward demand from future periods.

Meanwhile, the debate surrounding the Federal Reserve's stance on rate cuts persists, especially after Chair Jerome Powell and other policymakers adopted a more hawkish tone last week in response to persistent inflationary pressures.

Eyes are now on Thursday's US GDP data and Friday's release of the Super Core derivative from the PCE index, a vital component of the Fed's preferred inflation gauge. These releases will be crucial in determining whether the Fed maintains its current policy stance, keeping rates higher for longer.

One of the key pillars supporting the optimistic view on US stocks was the idea that even if the economy proved exceptionally resilient, the most daunting policy scenario in 2024 would entail three insurance rate cuts, as indicated by the dot plot. Initially, equities acknowledged and accommodated market projections for between two and three rate reductions. However, when market sentiment shifted to anticipate fewer than two quarter-point cuts, this foundational aspect of the optimistic outlook began to falter.

The evolving narrative among traders is increasingly centred on the potential for a policy misstep. Firstly, the impact of aggressive fiscal stimulus last year cannot be overstated, with nominal GDP growth hitting approximately 8% in Q3 and around 6% for the entire year. This stimulus, however, led to a substantial budget deficit, creating a challenging funding environment and driving up the term premium last summer and fall.

Amidst this fiscal backdrop and rising term premium, the Treasury scaled back its anticipated coupon issuance, triggering significant demand for duration through the end of last year. Additionally, the unexpectedly dovish policy shift announced by the Fed further fueled this demand. Allowing the bond market to interpret its stance as extremely accommodative, we witnessed approximately seven rate cuts priced in for this year by early January, coupled with a 10-year yield of roughly 3.8%.

In essence, the combination of reduced coupon issuance and the Fed's dovish rhetoric precipitated a steep decline in rates. This rate drop facilitated a substantial rally in risk assets, generating a wealth effect and significantly easing financial conditions. However, this asset inflation contributed to the robust growth and higher-than-expected inflation data we are currently observing, which is now hindering the Fed from adhering to its prior dovish guidance.

Consequently, the bond market has adjusted to this unexpectedly hot data, now pricing in just 1.5 rate cuts for this year. In a worst-case scenario, some speculate whether the Fed needs to consider rate hikes again. While only time will provide clarity, the recent reversal in data trends has pushed the Fed back into a more hawkish stance, posing a headwind for equity valuations.

The interconnectedness of macroeconomic policy and financial markets isn't a collection of isolated events but rather an ongoing storyline.

It's crucial for policymakers, like the Treasury and the Fed, to heed a word of caution: decisions made for short-term expediency influenced by recency bias can quickly transform into long-term policy dilemmas