Inside Markets — Policy Uncertainty

Today’s risk-on trade follows dovish central bank developments and stronger-than-expected US retail sales for August. On the central bank front, a PBOC Reserve Requirement Ratio (RRR) cut of 25bp becomes the latest in a series of incremental stimulus measures. The next China-linked catalyst will arrive this evening with the release of industrial production and retail sales for August. The ECB hiked rates by 25bp, but its statement suggested the central bank may be finished with the hiking cycle.

The uptick in August CPI was mostly due to base effects and higher energy prices. Demand for crude oil remains strong as the OPEC+ production cuts result in a ~3.3mbd global supply deficit into Q4. The recovery in crude prices should result in OPEC+ increasing production during Q4, when the headwind from negative CPI base effects unwinds.  If we’re right, headline CPI should decline over three consecutive months beginning in January and the Fed will signal an end to its tightening cycle in February or March.  

With other conditions remaining the same, the S&P 500 (SPX) should be able to get through technical resistance in the 4525-4550 range once the Fed signals an end to its hiking cycle. We don’t expect that to happen at next week’s meeting with ongoing policy uncertainty capping SPX rally attempts well into Q4. From a technical perspective, a break above ~4550 could take the index as high at ~4710, but we see greater near-term probability for the SPX to test support in the mid-4300s.  The SPX should be fine during this period of subdued equity volatility. The problems start when volatility spikes, making the CBOE Volatility Index (VIX) the most important near-term market barometer.  In our opinion, VIX levels north of 22 will release building selling pressure and trigger further downside to test ~4300.