Fed's Dovish Turn Spurs Stock Rally: What Lies Ahead?

Fed's Dovish Turn Spurs Stock Rally: What Lies Ahead? 

The recent FOMC meeting, led by Jerome Powell, spurred a surge in stock prices as Powell took a more cautious stance than anticipated. Although Powell acknowledged sluggish progress on inflation, the announcement of reversing "Quantitative Tightening" (QT) excited investors.

Starting in June, the Committee will ease the decline of its securities holdings by decreasing the monthly redemption cap on Treasury securities from $60 billion to $25 billion. The cap on agency debt and agency mortgage-backed securities will remain at $35 billion monthly, with any excess principal payments reinvested in Treasury securities.

This reversal of QT means a return of buyers to the Treasury bond market, enhancing overall market liquidity and reducing the Treasury's gross issuance by $105 billion in Q3. The bond market also reacted, expecting lower yields ahead due to the Fed's renewed bond market involvement, thus alleviating financing pressure in the economy.

The recent market downturn coincided with a sharp drop in liquidity as the Treasury General Account surged to nearly $1 trillion from April tax receipts. However, this liquidity is expected to be released into the economy over the next few months, coinciding with the Federal Reserve's reduced balance sheet runoff, further boosting overall liquidity.

The market had previously endured a reduction in liquidity, with higher rates and the reversal of QE causing a 20% decline in 2022. Investors began anticipating rate cuts and a return to balance sheet expansion, prompting a stock rally.

However, despite last week's surprising stock rally amidst weaker economic data, there are indications that the correction may not be complete. The market had previously seen a 5.5% drawdown when it violated the 20-DMA, with support found at the 100-DMA. Now, the stock rally is testing crucial resistance at the 50-DMA.

The stock rally's outcome remains uncertain, with three possible scenarios: breaking above the 50-DMA to retest previous highs, a retest of the 100-DMA due to "trapped longs" seeking to reduce risk, or a less probable reversion to the 200-DMA fueled by concerns about Fed policy and economic data.

While concerns about a deeper decline persist, there is limited evidence of market stress, with volatility remaining subdued and credit spreads staying below the long-term average. Additionally, the reopening of the stock buyback window, coupled with significant buyback announcements from tech giants like Apple and Google, supports the recent stock rally.

Although Powell's dovish shift contributed to the rally, managing risk remains crucial as the correction may not be over yet, especially considering potential economic uncertainties and portfolio risks ahead.