E-mini Dow Jones Industrial Average: Inflation Trend will Dictate Tone of the Market in 2016

Last week’s rally in Nearby E-mini Dow Jones Industrial Average futures contract put the market slightly higher for the year. The price action this week will determine whether investors will take a run at a new contract high or settle lower for the year. The key number to watch this week is 17424.

For the first six months of the year, the Dow traded sideways to higher. The uncertainty over the timing of the Fed rate hike had investors confused for several months so some investors decided to take advantage of the low interest rates while they had a chance.

The high of the year on May 19 at 18082 was made the same day the S&P 500 top was made so it wasn’t a fluke. It occurred a few days before a key speech by Fed Chair Janet Yellen and several weeks before the Chinese stock market started its eventual meltdown.

Yellen sealed the top end of the market when she said that despite the fact that economic growth had moderated somewhat, she still expected the Fed to start raising its benchmark interest rate later this year. The statement started the clock towards a rate hike, but no one knew when it would take place. However, her words were strong enough to stop the rally in its tracks.

When the Fed did eventually raise rates on December 16, it did so because the labor market had reached the mandated 5.0% unemployment level and because inflation was close enough to the mandated 2.0% level.

Currently, Fed Funds traders are pricing in the next rate hike for June 2016. Throughout the first six-months of the year, investors will be closely monitoring the jobs market and the inflation rate to make sure we are still on track for this rate hike. If inflation heats up faster than anticipated then we may even see an earlier rate hike.

We could be looking at a sideways market for the first six-months of the year if the economic data is mixed. With the unemployment rate at the mandated 5.0% level, the key to the Dow’s direction in 2016 will be inflation.

The purpose of raising rates is to gradually withdraw stimulus and to cool off the economy enough to keep future inflation from rising much above the Fed’s target rate. When Yellen gave her speech, she explained why she and other officials were inclined to move sooner rather than later.

The direction of crude prices will be very important in 2016. Stocks may benefit if crude oil rises because it will help prop up the energy stocks. This would underpin the Dow and the S&P 500. Higher energy prices will also help to drive up inflation which will solidify the next Fed rate hike.

The time period before the first rate hike could be very volatile with investors reacting to the price action in crude oil and its impact on consumer inflation. The Dow may actually rally until the Fed makes its second rate hike. The direction of the market after the second rate hike will be determined by the frequency of the Fed hikes. The faster the Fed tightens, the weaker the Dow will become.