Thursday, April 11

The Massive S&P 500 Rally May Now Be Over (NYSEARCA:SPY)

Alaska Brown bear (grizzly) looking forward as he climbs on a rock

John Morrison/iStock via Getty Images

The S&P 500 ETF (NYSEARCA:SPY) ripped higher following the May 4 Fed meeting. As the VIX index plunged, the SPY surged, indicating the rally had more to do with an implosion of implied volatility levels than excitement over the Fed’s plan, which is in no way bullish for equities. The Fed has laid out a plan that will lead to multiple 50 bps rate hikes, a run-off of the balance sheet at up to $95 billion per month, and is targeting tightening financial conditions. None of this will help to support equity prices over the longer term.

The S&P 500 ETF is likely to see this rally fade for many reasons, specifically because crucial data points are on the way, such as the jobs report on Friday, May 6, and the CPI report on Wednesday, May 11. These unknown events are likely to weigh on the S&P 500 ETF as investors look to put hedges back in place, causing implied volatility levels to rise.

Hedges Re-Build

Today’s FOMC meeting may emphasize the jobs data Friday morning, especially following a weak ADP report and ISM services employment index and contraction in April. Worries of a weak jobs report should again bring traders looking to repurchase put options, pushing the VIX higher and the S&P 500 ETF lower.

Currently, estimates are for 380,000 new jobs in April, with an unemployment rate of 3.5%. But more important is the average hourly earnings number, which is estimated to be up 0.4% month over month and 5.5% year over year. The most prominent risk that traders would want to hedge against would be a weak employment number or wages that were running over forecasts.

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Ultimately, buying puts and looking for hedges into the jobs report could weigh on the S&P 500 ETF and its near 6% rally off of Monday’s lows through Wednesday’s close. But more importantly, should the data disappoint, it is only likely to add fuel to the fire. Then with the CPI and PPI reports to follow next week, this process will likely repeat with hedges continuing to build up.

Fragile Legs

The actual rally has been built on a fragile technical picture. The technical chart shows a rapid rise from May 2 in a near-vertical advance. Over the past few weeks, when the S&P 500 ETF has moved up quickly, we have seen those gains often given back nearly as fast. If the pattern continues to play out, one would expect the rally to vanish and a new low to follow, undercutting the lows of May 2 at around $405.

Additionally, the ETF has hit a wall of resistance at around $430, and that level has been challenging for the last two weeks. However, a push above $430 could send the ETF up to $440. However, I think that will be difficult given the event risk and the reason stated above.

SPY price chart

Trading View

The Importance of Reserve Balances

More importantly, the Fed plans to make a series of 50 bps rate hikes. Additionally, its plans to run off the balance sheet, which will help to reduce reserve balances and drain liquidity from the financial system. The drop in reserve balances will likely reduce margin debit balances and remove leverage from the equity market, which has been so crucial to the success of the rally.

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debit balances in customer's securities margin account and RESERVE BALANCES WIHt fed banks

Mott Capital Management

Additionally, the Fed increased the interest rate for the overnight reverse repurchase agreement operations to 80 bps from 30 bps at the May meeting. The overnight reverse repo operation already draws around $1.8 trillion in daily activity, and the increase in the rate may increase the amount of the daily reverse repo activity. An increase in reverse repo activity would likely reduce reserve balances at an even faster pace.

Reserve balances exploded higher when the Fed started the QE process at the start of the pandemic, and now those reserve balances have been dropping. There is about a 2-week difference between what happens in reserve balances and the S&P 500. Based on this relationship, the S&P 500 ETF should fall as balances drop and excess liquidity is drained from the financial system.

SPY chart


Rising Real Yields Contact The PE

Additionally, as the Fed continues on this path of raising rates, real yields will need to rise further, which will lower the S&P 500’s PE ratio. The easiest way to track this relationship is to overlay changes in the TIP ETF (TIP) with the S&P 500 PE ratio. As the TIP ETF has risen, the PE ratio of the S&P 500 has risen. It seems reasonable that as the TIP ETF has now fallen, the PE ratio of the S&P 500 has followed.



Rising rates and a declining balance sheet will make a longer-term advance in the S&P 500 ETF very challenging, whether the Fed raises rates by 75 bps at a meeting or increases rates steadily at 50 bps per meeting. Regardless, the Fed will be raising rates aggressively and will look to get those rates well over 2% on the Fed Funds rate, tightening financial conditions and reducing the balance sheet. If all of this helped lift stocks when the Fed was easing monetary policy, then all of these things will work to push stocks lower as the Fed is tightening monetary policy.

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