By the time this article is posted, the Federal Reserve will have enacted its latest round of interest rate hikes. Mr. Powell will have held his press conference. And the market will have reacted.

My guess based on information I have prior to the decision, which for once, goes along with the Wall Street consensus, is for a 25-basis point increase in the Fed Funds rate and perhaps (big asterisk here) some sort of language which hints at a pause in the rate hikes. The Bank of Canada has given the Fed some cover on this, via its most recent actions and the accompanying signal that it will pause to “gauge” the effects of its rate hikes on the economy.

Mostly my expectations are based on recent data which suggests the rate of rise in inflation has flattened out. In addition, it’s widely accepted, and confirmed by several Fed speakers that it takes several months before the Fed’s rate hikes will work their way through the economy. Therefore, given the accepted time lag, it would not be out of the realm of expectations for the Fed to signal a pause after a year of rate hikes.

I don’t believe in those time lags anymore, as I will explain below. But the Fed does, and what they believe matters more than what I believe in terms of how they set interest rates.

Certainly, there is nothing I can do about what the Fed says and does. But I can prepare for what happens next. For that I look at how the markets are set up before the rate increase. Moreover, given the fact that the financial markets in many ways drive the economy, how the markets respond will likely influence how the economy responds.

Bonds Are Betting on a Slowing Economy

The bond market is usually a topic which is guaranteed to be an eye-glazer at parties. But to ignore the place where trillions of dollars exchange hands on a weekly basis is pure folly. That’s because the action in the bond market sets interest rates for mortgage rates, and consumer loans, especially auto loans and distantly credit card rates. Thus, since debt makes the world go ‘round, it’s a good idea to monitor the debt markets to gauge how much financing costs will affect how we spend our money.

Specifically, the U.S. Ten Year Note yield (TNX) is the basis for most mortgages, while the Fed Funds roughly benchmarks auto loans and other consumer loans. If the Fed raises rates another 25 basis points, they will reach the 4.5%-4.75% area. That will likely translate to the average auto loan to move above 7% for a 48-month lease for average buyers; much higher for lower rated customers. On the other hand, slowing auto sales will likely spur dealers to increase their promotions which often offer 0-3% rates to customers with excellent credit.

More important is what happens to mortgage rates (Mortgage), which are hovering just above 6% for the average 30-year loan.

You can see the close correlation between the U.S. Ten Year yield and the average mortgage rate. Over the last four months Treasury bond yields have fallen steadily and mortgage rates have followed. This has led to what may be an important bottom in the housing sector.

Data from the National Association of Realtors for December showed a month-to-month 2.5% increase in pending home sales, with the West and the South leading the way with over 6% month to month gains. The year-over-year data was still dismal with a 37.5% overall decrease in all regions.

Note the equally close correlation between lower bond yields, lower mortgage rates and the rally in the homebuilder sector (SPHB).

Stocks are the Fuel for the Economy

I base much of my analysis on the concept that the stock market is a greater influence on the economy. This is in direct contrast to the traditional view which is that what happens in the economy is the major influence on the stock market. I refer to this complex relationship between the stock market, the Federal Reserve and the economy as the MELA system, where M is for markets, E is for the economy, L is for life decisions, and A is for artificial intelligence – aka algos.

In MELA, the central concept is that the value and trend of a stock portfolio, such as what happens to trading accounts (including crypto), 401k plans and Individual Retirement Accounts (IRAs) influences the economy. That’s because of the wealth effect. When trading accounts rise in value, people feel better and are willing to spend money. They increase the financial risk taking in their life decisions. This psychology is what drives the economy, not the other way around.

Artificial intelligence includes the 24-hour news cycle and social media. Since everyone is plugged in via their cell phone and other electronic devices, news travels fast. Moreover, the public has either consciously or subconsciously figured out that when their trading accounts are in better shape. Loan applications seem to be approved faster and more smoothly, as long as they are employed.

What it all boils down to is that when stocks are rising, everyone is in a better mood and commerce moves more freely.

The Line Between Bull and Bear Trends

Over the last few weeks, I’ve written extensively about a technical indicator known as the 200-day moving average. This is the line between bull and bear trends in any market, but especially the stock market. You can find the articles here and here.

Generally speaking, when prices trend above this line the market is in an uptrend. The opposite is true when the market is trending below this important indicator.

Perhaps the most important aspect of this line in the present is that artificial intelligence based trading programs (algos) are instructed to buy stocks when the market is trading above this line and to sell them when the opposite is true. By some estimates as much as 80% of the trading volume on Wall Street results from algo trading, so this line is an even bigger deal than it used to be.

As it stood before the Fed’s big decision on February 1, the S&P 500 (SPX) was trading above its 200-day moving average, and the key 4000 price point. Algos have been buying, thus the positive vibe in the markets.

The Lines in the Sand

When the Fed makes its intentions known, investors should watch two crucial price chart points (lines in the sand):

• The S&P 500 and its relationship to the 200-day moving average, and
• The U.S. Ten Year Note yield and its relationship to the 3.5% yield and its own 200-day moving average, which is near 3.4%.

If SPX holds above its 200-day line and TNX breaks below its two critical lines in the sand, the odds will favor what could be a rather large rally in stocks. If SPX breaks below its 200-day line and the TNX yield rises, it will likely lead to a rapid decline in stocks and an equally nasty climb in interest rates.

If the former scenario unfolds, expect an improvement in the economy to follow. If the latter scenario becomes evident, we may be headed for a recession. That’s because in the MELA world, the markets influence the economy, and the relationship between market interest rates (bond yields, mortgages, and auto loans) is directly related to what the Federal Reserve says and does.

One final note: Thanks to the algos, news travels fast. It’s a good idea to stay plugged in.

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