The Fed won't have to kill every stock market rally once it raises interest rates to neutral this week, Fundstrat says

• Fed Chairman Jerome Powell doesn't have to kill every stock market rally, according to Fundstrat's Tom Lee.
• That's because the Fed is likely to raise interest rates to its neutral target of 2.5% this week, he said.
• "The risk/reward is skewed to upside in 2H, [and] if inflation cools, Fed doesn't have to kill every stock rally," Lee said.

The Federal Reserve has had a knack for killing stock market rallies in recent months as it aggressively raises interest rates to combat a 40-year high in inflation readings.

But that trend could soon end, according to a Monday note from Fundstrat, as inflation begins to cool and the Fed reaches its neutral target interest rate of 2.5%. The Fed is expected to raise interest rates by 75 basis points on Wednesday, which would put the upper bound of the Fed Funds rate right at 2.5%.

The Fed's target neutral interest rate is defined as not being stimulative nor restrictive of overall economic growth.

"In fact, after July FOMC, the entire yield curve will be above the 'neutral' rate: meaning, the bond market is doing the work of the Fed [and] all cost of money is above the neutral rate," Lee said.

Reaching the neutral rate means the Fed will have more options in its future rate hike trajectory and will be able to better respond to inflationary data. And with inflation showing signs of rolling over, as evidenced by falling commodity prices, that sets the stock market up for more upside in the second half of the year as it allows the Fed to pause rate hikes.

"If inflation pace is falling faster than consensus expects, equity rally is reflecting this 'downside surprise,' thus, Fed doesn't need to quash a rally," Lee said.

Ultimately, he sees some parallels between the Fed's current rate hiking trajectory and former Fed Chairman Paul Volcker's rate hike cycle in the early 1980s. Back then, the S&P 500 fell 27% and the economy saw a "manufactured" recession that is relatively easy to recover from.

The early 1980's market action is nearly in-line with the stock market's peak-to-trough decline of 25% so far this year, while US GDP growth is on the verge of flashing two consecutive quarters of contraction, which many consider to be a technical recession. 

"The inflation duration is far shorter today, thus, 25% decline seems like an overshoot," Lee said, observing that internal market valuations have cratered in recent weeks, along with investor sentiment readings.

"The risk/reward is skewed to upside in 2H, [and] if inflation cools, Fed doesn't have to kill every stock rally...thus, we see 2H rally intact," he concluded.