The stock market rally faces a conundrum as inflation can’t fall enough to please the Fed while the economy is this strong

• Investors piling into the current rally in stocks could face trouble in the third quarter, DataTrek said.

• That’s because inflation may not fall enough while the economy stays strong.

• The firm warned that rate hikes could continue, which would be a headwind for the stock market.

Investors have been riding a wave of bullishness this quarter, but the rally in stocks could face trouble, as inflation can’t fall much further while the economy remains this strong.

That’s according to DataTrek Research, which in a note on Thursday pointed to the strong performance of stocks this year, with the S&P 500 up 12% since January. The benchmark index rose 3% over the past 30 days alone, partly fueled by a slight decline in inflation and expectations that the Federal Reserve will pause rate hikes at its policy meeting next week.

But the rally could falter soon, as prices may not be able to ease to the Fed’s 2% inflation target without additional rate hikes, the firm said.

“The fly in that optimistic ointment is the threat that a strong economy and declining inflation are mutually incompatible, and the Fed will be forced to keep raising rates in this scenario. Markets have gotten the ‘peak Fed’ call wrong 3 times so far; a fourth unforced error is not out of the question,” DataTrek co-founder Nicholas Colas said.

Colas predicted that the rally in stocks will continue through the end of June, though the market could face a conundrum in the third quarter as inflation and Fed rate expectations become repriced. Currently, markets have priced in a 72% chance the Fed pauses rate hikes at the June 14-15 meeting, but a 50% chance rates will rise another 25 basis-points in July, per the CME FedWatch tool.

Central bankers have raised interest rates aggressively in the past year to lower inflation, a move that’s weighed heavily on stocks and threatens to tip the economy into recession.

Meanwhile, inflation is still well-above the Fed’s target, with prices coming in at 4.9% in the April Consumer Price Index report. Core CPI measured at 5.5%, a sign that inflation pressures in the economy are still strong.

Commentators have warned more rate hikes are in order before the Fed gets inflation fully under control, though higher rates will likely be a headwind for stocks. The S&P 500 slumped 20% last year amid the Fed’s aggressive interest rate hikes, notching its worst performance since 2008.

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