The U.S. stock market is approaching a crucial turning point as uncertainty over inflation rises after hotter-than-expected economic data released in February. Despite mounting investor worries, the economy is showing signs of resilience that could protect it against a significant downside move.
The escalating risk-off sentiment in the market is also creating volatility for Bitcoin (BTC). The leading crypto asset, which has had a strong correlation with the U.S. stock market, moved opposite to the stock market in February, with a correction between BTC and the Nasdaq turning negative for the first time in two years. However, with the crypto bulls pausing at the $25,200 level, the risks of a downturn alongside stocks are increasing.
While there’s certainly a reason to maintain caution until the release of new economic data and the United States Federal Reserve meeting in March, some indicators suggest that the worst may be over in terms of the market making new lows.
Inflation remains sticky
The biggest worries of the current bear cycle, which began in 2022, have been decade-high inflation. In January, the Consumer Price Index (CPI) came in hotter than expected, with a 0.2% increase versus the previous month.
There are some additional signs that inflation may remain sticky. Inflation in the housing sector, which commands more than 40% of the weightage in the CPI calculation, has shown no sign of a downturn.
It appears that the market is slipping back into the 2022 trend where increasing inflation corresponds to higher Fed rate hikes and poor liquidity conditions. The market’s expectation of a 50-basis-point rate hike in the upcoming March 22 meeting has increased from single-digit percentages to 30%. Fed President Neel Kashkari also raised concerns that there is a lack of signs showing that Fed rate hikes are curbing inflation in the services sector.
However, a report from Charles Edwards, founder of Capriole Investments, argues that inflation has been in a downtrend with a minor setback in January, which is nonconclusive.
“Until we see this chart plateau out, or increase, inflationary risk is overstated and the market so far has overreacted.”
The release of the February CPI on March 12 will be instrumental in creating market bias in the short term.
Edwards says recession risk is lower than ever
Despite high inflation levels, the risk of a recession in the stock markets has reduced considerably. Edwards notes in the report that the job sector remains robust with low unemployment levels, which is striking, especially at the “late end of the cycle.” He adds:
“Ultra low unemployment paired with high interest rates increases the odds of an unemployment bottom being in (or forming).”
However, the market is also more sensitive to rising unemployment from here. If the unemployment levels react to the Fed’s hawkishness, a stock market downturn due to recession risks could rise quickly. February’s job sector report is set to release on March 10.
According to the report, the worst downturns in the S&P 500 index over the past 50 years when similar recessionary fears were prevalent have been -21%, -27% and -20%. The latest 2022 bottom also tagged the -27% downturn mark, which is encouraging for buyers. It raises the possibility that the bottom may be in for the S&P 500.
Currently, the S&P 500 and the tech-heavy Nasdaq-100 index are at risk of breaking below the 200-daily moving average (MA) at 3,900 and 11,900 points, respectively. It raises the possibility that the late 2022 and early 2023 increase may have been another bear market rally instead of the start of accumulation with the bottom tagged for this cycle. A move below the 200-day MA for the stock market would add additional pressure on the crypto market.
Notably, in December, when the stock market was surging higher, crypto markets stayed flat in the aftermath of the FTX collapse. In early 2023, the crypto markets likely played catch up to the stock market, and currently, it might be experiencing the tail end of the opposite reaction.
A possible bear trap?
As the Fed prepares for renewed hawkishness, there is more pressure on the upcoming debt limit crisis of the U.S. Treasury. Since mid-2022, when the Fed started quantitative easing, the U.S. Treasury has facilitated backdoor liquidity injection. However, the added liquidity from the Treasury will be drained entirely by June 2023.
The market’s optimism earlier this year was probably related to the assumption that the Fed would start easing interest rates by the time the Treasury’s funds dry out. However, if inflation grows again and the Fed continues increasing rates, the economy will be in a precarious position by June, with expensive credit and limited liquidity from the Treasury.
Still, as Edwards mentioned, “there is no doubt risk in the market,” but the economy is in a much healthier position than expected. The probability of a recession is down to 20% from 40% in December. The current weakness could be a bear trap before sentiments improve again. A lot will depend on the economic data release this month and price action around crucial support levels.
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