A confrontation between the unstoppable stock market and the unmovable federal reserve is imminent

In a quick start to the year, the stock market seems as if it doesn't know about the Federal Reserve. This week, the Fed will raise interest rates again, with Jerome Powell serving as chairman.

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There was a 1.8% gain for the Dow Jones Industrial AverageDJIA –0.30%, a 2.5% gain for the S&P 500SPX –0.88%, and a 4.3% gain for the Nasdaq CompositeCOMP –1.48%. Almost 14% has been added to the S&P since its early October bear-market low, making this S&P's third gain in four weeks.

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The reason for that rally isn't a big secret. Markets are betting that inflation will fall enough for the Fed to stop hiking interest rates in the near future. Of course, that would be good news for investors, who fear that a tightening by the central bank will cause a recession.

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All the signs are positive, but there will be an announcement by the Fed on Wednesday, and it is possible that the central bank will appear to be pushing back against the bulls' expectations. There's a near certainty that the federal-funds rate will rise by a quarter-point with the Federal Open Market Committee's rate hike.

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Consumer price indexes as well as PCE deflators are above the Fed's target of 2%, but inflation remains higher than it was last year. A stock market rally can't be a good thing for the central bank when financial conditions ease. There will be a response from the chairman.

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“In spite of the softer inflation data, Powell is likely to maintain rates for a while,” writes Citigroup's Andrew Hollenhorst in a recent report.

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In January, the Nasdaq gained 11%, its best January since 2001, due to the Fed's desire to tighten credit conditions. Despite companies like Microsoft MSFT –2.12% (ticker: MSFT) and Texas Instruments (TXN) continuing to guide earnings lower, the S&P 500 looks expensive at 17.9 times earnings, up from 16.7 at the end of 2022. According to Benson Durham, Piper Sandler's head of global asset allocation, high valuations suggest some meaningful downside.

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While valuations should not be a factor, the S&P 500 has now reached a level that has been difficult to surpass in the past. It has recently breached its 200-day moving average, but remains a few points below 4100, a level where sellers have repeatedly knocked it down.

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Kolovos, chief technical strategist at Macro Risk Advisors, says the index could reach that level even if the Fed sounds moderately hawkish, but a more substantial rally is unlikely without more convincing signs that the economy is on the mend.

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In the end, the market is not in a great position before the meeting of the FOMC. Wells Fargo Securities' chief U.S. equity strategist Chris Harvey says the risk-reward doesn't seem appealing going into Fed day. It is not what the market wants to hear from Powell that he will continue to focus on tighter for longer."

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I don't think it has been listening.

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