May's Macro Meditation

Hey everyone,

Let's face it: Jerome Powell is the ultimate celebrity in financial markets.

Our beloved Federal Reserve Chair is like the pop star of the financial world. When he takes the stage, the entire global economy holds its breath, waiting with bated anticipation for his every utterance. It's as if the world stops spinning, and we all become Jay Powell groupies, hoping he'll toss us a scrap of insight or a tantalising tidbit to fuel our financial fantasies.

Unfortunately, that doesn't usually happen. Every analyst on planet Earth will dissect his every word for the next week to tease out those insights. And, to be honest, I'm glad Jay Powell doesn't give it all away in one go. That would be too easy.

So, during the week of the most important FOMC meeting since the last one in March, we gather again like overeager teenagers at a rock concert, ready to feast our ears on Jay Powell's sweet serenade.

Let's get into it.

May's Macro Meditation

Although we made out like the event was equivalent to a rock concert, it's a mixed bag at the best of times.

Unfortunately (or fortunately?), there were no surprises this time, with the Fed raising interest rates by 25 bps (0.25%), pushing the Fed Funds Rate to a target range of 5%-5.25%. As a result, we now sit at the highest interest rate levels since the Global Financial Crisis in 2008.

So, no wonder the market's eager for a pause, maybe even some rate cuts this year. A pause in interest rate changes for June's FOMC meeting is priced into current market expectations with a 92% probability. At the same time, the market has priced possible rate cuts by July with a 50% probability.

The Fed, however, isn't keen on pivoting to rate cuts without a good reason—like a fragile economy or a struggling labour market. So, with inflation still lurking above the 2% target, the Fed is showing they’re serious about bringing it all the way down.

And this stance is backed up by Powell's statements from Wednesday, with him stating that "a decision on a pause was not made today."

Powell doubled down on his sentiments toward inflation, reiterating that "Inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go, and we remain strongly committed to [that] goal."

It's doubtful that inflation is going to drop down to 2% anytime soon, let alone by this summer, with CPI and PCE (the metrics of inflation the Fed pays the most attention to) remaining sticky:

I know what you might be thinking - surely if they get to 3% inflation, that'll be low enough and they can pivot? Not quite, Powell had this to say: "We are not looking to get to 3% <inflation> and then drop our tools."

The labour market also isn't doing anything to increase the odds of a Fed pivot. As Jay Powell had to say: "The labour market remains very tight", and the fact is, he's right.

There are still around ten million job openings in the US as we stand - yes, it's been trending down this year but not as much as you'd expect given the recessionary narratives floating around. From this perspective, the demand for labour far exceeds the supply.

Additionally, unemployment has hardly increased since the massive COVID-19 spike in April 2020 - another sign that the Fed's tightening is taking longer to dampen the labour market.

At this point, it's worth reflecting on the Fed's dual mandate. First, the Fed's fundamental purpose within financial markets is to manage its monetary policy (interest rates) to promote stable prices (i.e. keeping inflation at its 2% target) and maximise employment.

As we can see, the labour market shows incredible strength, and unemployment is at its lowest level in 50 years. So, labour market - tick.

Inflation is proving to be the enemy that won't lie down. It's clear that the Fed will have to keep raising rates for Jay Powell to stick to his word. In fact, on Wednesday, he was unwilling to say if 5.25% is sufficiently restrictive or not and that the Fed will remain "data dependent" in revisiting their terminal rate for June's meeting.

We've heard that one before. The sky is the limit for Jay Powell regarding rates and how much they can rise to break inflation.

The one thing that may stop Powell from fully emulating his predecessor Paul Volker (who famously broke the back of inflation in the 80s) could be the banking crisis that just hasn’t gone away.

With systemic bank failures a firm reality in the market, we may have a pseudo-rate hike on our hands - as Powell's said before, tightening credit conditions caused by bank failures have the same economic effect as hiking rates.

However, while Powell was spot on with his decision-making on Wednesday regarding inflation and the labour market, his lack of acknowledgement of the ruin within the US banking system is astounding.

"The US banking system is sound and resilient." Really Jay?

What about the half a trillion dollars’ worth of bank failures that went down in the past two months? And the fact that this year’s banking failures have been at a larger scale than all the banks that shut down in 2008, and we’re not even halfway through the year?

The reality is that, like SVB, US banks that haven’t hedged their interest rate risk are sitting with an impossible load of losses on their balance sheets from their investments in long-dated bonds having yields near zero. Moreover, with rates being jacked up at an unprecedented pace over the past year, the value of those bonds (assets on the bank's balance sheet) has cratered. This is because bonds issued in the last year can generate much higher yields.

So unprotected banks will continue to get crushed. And this is why Powell has his hands tied.

Decide to raise rates to bring down inflation, and he risks wiping out US regional banks by exacerbating their bond losses—or cut rates to save the banks and tempt a resurgence in inflation.

It's an impossible situation from Powell's perspective. So you can understand that he'd want to instil confidence in the banking system even if the opposite is true. Sometimes, when you're between a rock and a hard place, the best thing is to pretend the rock doesn't exist.

Additionally, any acknowledgement of weakness from his side would signal to the market that things are worse than they seem right now, given his position.

We have to applaud his deflection tactics regarding the banking system. It's a shame they proved to be in vain when PacWest Bancorp, a California-based regional bank, reported that they were "weighing a range of strategic options, including a sale" hot on the heels of the Fed's meeting on Wednesday.

The hard pill to swallow was that the bank's financial conditions had worsened far more than the Fed had anticipated.

Sure enough, with $28 billion in deposits and $44 billion in assets, the bank saw its stock plunge more than 60% after hours on Wednesday.

But PacWest was the week’s first penny to drop. Thursday saw absolute carnage in the equity markets for US regional banks, with red across most stock tickers. The biggest loser, in addition to PacWest, was Western Alliance, which saw its stock drop 60%.

Powell's interest rate decision on Wednesday has sparked a fresh round of banking contagion fears, with the stranglehold on these banks' balance sheets becoming ever tighter. Adding insult to injury is that JP Morgan's deal to acquire defunct regional bank First Republic hasn't done much to subside fears.

This paints a pretty bleak economic picture when looking at the possibility of further bank contagion alongside the Fed's undeterred resolve to keep raising rates.

It's a fool's errand for us to speculate what will happen in financial markets at the best of times. Adding in all this conflicting sentiment and data in the macro environment makes predicting the rest of this year even more challenging.

However, we can glean slivers of insight from robust technical analysis. This type of analysis, when done correctly, helps filter out the noise and allows us to isolate a direction that prices could be heading in, with probabilities attached to possible outcomes.

For our analysis, it’s essential to keep in mind that our main focus is on the relevant levels that are being hit and not necessarily the timeframes. Although we’ve given estimates of timeframes for the scenarios to play out, if a particular level is hit within our analysis, we’re asserting where the next level is on the chart that the price will move to, irrespective of how long it’ll take.

So let's dive into a few setups that will be telling for the rest of the year.

The two essential charts we’re monitoring right now within traditional markets are the US Dollar Index (DXY), a relative measure of dollar strength, and the S&P 500. We’ll also focus on Bitcoin as it’ll be the leader in general crypto market movements. The analysis below gives us guidance for the market direction over the coming weeks and will set the tone for direction for the rest of the year.

Looking at the DXY, we currently sit near a key weekly low of 100-101. This is an area of interest as it sits within our range of support and daily overhead resistance. It’ll be crucial to see if these weekly lows hold over the next week.

If we see the DXY rollover, we’ll likely see a swift move down to the 98-99 region shown on the chart. This’ll be bullish for risk markets (i.e. equities and crypto).

However, if we see the DXY break the downtrending daily resistance (the dotted line) and push up to flip the 12-hour grey resistance block, we’ll see the DXY trend up to the 104-105 region, which’ll be bearish for risk assets.

So, how does the shift in the DXY relate to the S&P 500?

Right now, we’re sitting below a significant level of resistance (that big, ominous-looking red block) at the 4,200 level. It’s evident that we’ve tested this region many times in 2021 and early 2022 as a line of support before losing it to become a zone of resistance. Since the flip, we’ve seen this region tested six times over the course of 2022 and 2023.

If the DXY breaks to the upside per our earlier scenario, the rejection of 4,200 should send the S&P 500 back to sweep the 200-Day moving average at around 4,000. However, if the DXY rolls over, the 4,200 level should flip to support again, followed by a drastic push-up for equity markets into the back end of the year.

At this point, it’s essential to keep the current negative economic environment in mind. With so much bearish sentiment floating around, any bullish catalysts seem unrealistic at this point. So, if we do break above the 4,200 level, this could very well supercharge the bear market rally narrative and send us to test the 4,325-4,400 levels.

And finally, how does that all correlate with Bitcoin?

Looking at the daily chart, we’re maintaining the 50-day Exponential Moving Average (the wiry yellow line) as strong support while hovering below the grey bearish weekly order block.

While a push to $31,000 or $32,000 in the short term is very possible for Bitcoin, it’s more likely we’ll see the $24,000-$25,000 region being tested on a technical front before we see the next medium-term leg of this rally to the $36,000 region. In fact, a retracement as deep as the 0.5 or 0.618 Fibonacci levels (which takes us to the $21,500/$23,000 region, in line with the 200-Day moving average) would still be notching a “higher-low” on the macro timeframe.

Taking a step back, based on technical levels out to the end of 2023, the 4,300-4,400 levels are likely to be the upside cap on the S&P 500, while $36,000-$42,000 is the peak for Bitcoin.

Overall, all eyes are on the DXY. The macro-outlook for crypto is bullish, in our opinion, with the caveat that we may well see a 20-30% retracement before the next big leg up in the market over the rest of the year. However, that can all change in the short term if the DXY falls and the S&P 500 rockets out of the 4,200 level.

So, our bias based on the technicals is for higher prices by the end of 2023, even with short-term retracements.

Paradoxically, that claim probably seems outlandish, given all the doom-and-gloom we discussed earlier. Between Jay Powell being unrelenting in hiking rates to the banking crisis that doesn’t want to call it a day, there’s a serious bleak picture being painted from a fundamental economic point of view.

But, the reality is that markets rarely behave in the way that you think they will let alone how you desire them to.

That’s why what Morgan Housel has to say here is profound:

There’ll always be bad news - the economy could be one bank closure away from economic depression, and doomsday might be one rate hike away. But markets can keep moving up. That is the reality of this irrational, wonderful game we play.

This is why we reverted to the charts to tell us something - to give us direction. With so much conflicting news, data and sentiment, deciphering where markets will land in the future is just too hard right now. Sometimes it’s worth taking a step back, cutting out the noise and keeping things simple.

This is what we’ve done, and we motivate you to do the same. Accept what Housel is saying and move forward with the data points that matter.

That’s how we’ll win the wonderful game, no matter how many times Jay Powell jacks up interest rates.

Thank you for reading. Share the post with a friend if you found it insightful.

— Luca