SPY – Medium-Term Risks Building, But Can Rally Near Term

On the weekly chart, SPY remains grossly overbought, but near term there is room to rally – duration and magnitude notwithstanding. Options can help.

US core PCE (personal consumption expenditures) increased 1.96 percent year-over-year in May – essentially two percent. The last time this metric, which is the Fed’s favorite measure of consumer inflation, rose with a two handle was in April 2012. Also in May, core CPI (consumer price index) rose 2.24 percent y/y. This was the third straight month of two-plus reading. In general, core CPI comes in stronger than core PCE. Most recently, they both bottomed last August at 1.68 percent and 1.30 percent respectively, and have trended higher since (Chart 1).

The Fed has a two-percent inflation target on core PCE, which was just about hit in May.  In the June (12-13) FOMC meeting, during which the fed funds rate was pushed up by 25 basis points to 175 to 200 basis points, the dot plot forecasted four hikes this year, up from a forecast of three during the March (20-21) meeting. Rates were also raised in the March meeting. If the FOMC forecast comes true, two more hikes await us in the remaining four scheduled meetings this year.  In the futures market, September (25-26) currently has 72-percent probability of a 25-basis-point hike, while December (18-19) is on the fence. Two additional hikes in the remainder of the year puts the fed funds rate at 225-250 basis points – obviously not as accommodative as when the Fed began hiking in December 2015. But is it restrictive? Too soon to tell, but arguably bond vigilantes are beginning to grow concerned.

The recent inflation trend gives FOMC hawks a good cover to maintain a restrictive stance. The long end of the curve, however, has other ideas. Last Friday when May’s core PCE was published, 10-year Treasury yields (2.85 percent) reacted with a yawn. Ditto with the spread between 10- and two-year yields, which inched up one basis point to 33 basis points (31 basis points last Wednesday was the lowest since August 2007). At the highs in December 2015, the yield curve was 137 basis points wide.