Why stock-market investors fear ‘something else will break’ as Fed attacks inflation

Some investors are nervous that the Fed may be tightening monetary policy too much in its bid to rein in hot inflation, as markets await a reading next week of the Fed’s preferred gauge of the US cost of living. USA

“Fed officials have been fighting to scare investors almost every day recently in speeches declaring that they will continue to raise the fed funds rate,” the central bank’s benchmark interest rate, “until the crunch breaks.” inflation,” Yardeni Research said in a note on Friday. The note suggests they went “trick or treating” before Halloween, as they now entered their “blackout period” which ends the day after the conclusion of their November 1-2 policy meeting.

“The growing fear is that something else will break down the road, like the entire US Treasury bond market,” Yardeni said.

Treasury yields have soared recently as the Federal Reserve raises its benchmark interest rate, putting pressure on the stock market. On Friday, their rapid ascent came to a halt as investors digested reports suggesting the Fed may discuss a slight slowdown in aggressive rate hikes later this year.

Stocks rose sharply on Friday as the market weighed what was seen as a possible start of a change in Fed policy, even as the central bank appeared poised to continue on a path of big rate hikes this year to rein in inflation. galloping.

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The stock market’s reaction to The Wall Street Journal’s report that the central bank appears poised to raise the fed funds rate by three-quarters of a percentage point next month, and that Fed officials may debate raising it by half percentage point in December. seemed too enthusiastic for Anthony Saglimbene, chief market strategist at Ameriprise Financial.

“It’s wishful thinking” that the Fed is headed for a pause in rate hikes, as it will likely leave future rate hikes “on the table,” he said in a telephone interview.

“I think they got cornered when they left interest rates at zero all last year” while buying bonds under so-called quantitative easing, Saglimbene said. As long as high inflation remains stagnant, the Fed will likely continue to raise rates while acknowledging that such hikes operate on a lag and could cause “more damage than they want” by trying to cool the economy.

“Something in the economy may break in the process,” he said. “That’s the risk we’re in.”

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‘Debacle’

Higher interest rates mean it’s harder for businesses and consumers to borrow, slowing economic growth amid heightened fears the US faces a potential recession next year, according to Saglimbene. . Unemployment may rise as a result of the Fed’s aggressive rate hikes, she said, while “dislocations in currency and bond markets” could emerge.

American investors have seen such cracks in financial markets abroad.

The Bank of England recently made a surprise intervention in the UK bond market after yields on its government debt soared and sterling sank amid concerns over a tax cut plan that surfaced when the bank Britain’s central bank was tightening monetary policy to curb high inflation. Prime Minister Liz Truss resigned in the wake of the chaos, just weeks after taking the top job, and she said she would leave as soon as the Conservative Party organizes a race to replace her.

“The experiment is over, so to speak,” JJ Kinahan, chief executive of IG Group North America, the parent of online brokerage Tastyworks, said in a phone interview. “So now we’re going to have a different leader,” he said. “Normally, you wouldn’t be happy with that, but since the day he arrived, his policies have been very unwelcome.”

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Meanwhile, the US Treasury market is “fragile” and “vulnerable to shocks,” Bank of America strategists warned in an Oct. 20 BofA Global Research report. They expressed concern that the Treasury market “may be one stroke away from the workings of the market.” challenges,” pointing to deteriorating liquidity amid weak demand and “elevated investor risk aversion.”

Read: ‘Fragile’ Treasury market at risk of ‘large-scale forced sale’ or surprise leading to collapse, says BofA

“The fear is that a meltdown like the recent one in the UK bond market could happen in the US,” Yardeni said in his note on Friday.

“While anything seems possible these days, especially scary scenarios, we would like to point out that even as the Fed is pulling liquidity” by raising the fed funds rate and continuing quantitative tightening, the US is a safe haven in amid tough times globally, he told the firm. In other words, the notion that “there is no alternative country” in which to invest besides the US can provide liquidity to the domestic bond market, according to his note.

YARDENI RESEARCH NOTE DATED OCT. 21, 2022

“I just don’t think this economy will work” if the 10-year Treasury yield TMUBMUSD10Y,
4.228%
the note is starting to approach anywhere near 5%, Rhys Williams, chief strategist at Spouting Rock Asset Management, said by phone.

Ten-year Treasury yields fell just over a basis point to 4.212% on Friday, after rising Thursday to their highest rate since June 17, 2008 based on 3 pm ET levels. according to Dow Jones Market Data.

Williams said he’s concerned that rising financing rates in the housing and auto markets will hit consumers, causing sales in those markets to decline.

Read: Why the housing market should prepare for double-digit mortgage rates in 2023

“The market is more or less priced into a mild recession,” Williams said. If the Fed kept tightening, “without paying attention to what’s going on in the real world” while “maniacally focusing on unemployment rates,” there would be “a very big recession,” he said.

Investors anticipate that the Federal Reserve’s path of unusually large rate hikes this year will eventually lead to a weaker labor market, reducing demand in the economy in its effort to curb runaway inflation. But the labor market has so far remained strong, with a record low unemployment rate of 3.5%.

George Catrambone, head of Americas trading at DWS Group, said in a telephone interview that he is “quite concerned” about the Fed tightening monetary policy too much or raising rates too quickly.

The central bank “has told us they are dependent on the data,” he said, but raised concerns that it is based on data that “goes back at least a month,” he said.

The unemployment rate, for example, is a lagging economic indicator. The housing component of the consumer price index, a measure of US inflation, is “sticky, but also particularly lagging,” Catrambone said.

At the end of next week, investors will get a reading of the personal consumption expenditures price index, the Fed’s preferred gauge of inflation, for September. The so-called PCE data will be released before the US stock market opens on October 28.

Meanwhile, corporate earnings results, which began reporting for the third quarter, are also “backward looking,” Catrambone said. And the US dollar, which has soared as the Fed raises rates, is creating “headwinds” for US companies with multinational businesses.

Read: Stock market investors are gearing up for the busiest week of earnings season. This is how it stacks up so far.

“Because of the lag with which the Federal Reserve operates, you won’t know until it’s too late that you’ve gone too far,” Catrambone said. “This is what happens when you move with such speed but also with such size,” he said, referring to the central bank’s series of big rate hikes in 2022.

“It’s much easier to tiptoe when you raise rates 25 basis points at a time,” Catrambone said.

‘Tightrope’

In the US, the Fed is on a “tightrope” as it risks tightening monetary policy, according to IG’s Kinahan. “We haven’t seen the full effect of what the Fed has done,” he said.

While the labor market looks strong for now, the Fed is adjusting to a slowing economy. For example, existing home sales have fallen as mortgage rates rise, while the Institute for Supply Management manufacturing survey, a barometer of US factories, fell to a 28-month low of 50.9% in September. .

Also, troubles in financial markets may come unexpectedly as a domino effect of the Fed’s monetary tightening, Spouting Rock’s Williams warned. “Any time the Fed raises rates this fast, that’s when the water comes out and you find out who’s got the bathing suit,” or not, he said.

“You just don’t know who is overleveraged,” he said, raising concerns about the possibility of illiquidity explosions. “You only know when you get that margin call.”

US stocks closed sharply higher on Friday, with the S&P 500 SPX,
+2.37%,
Dow Jones Industrial Average DJIA,
+2.47%
and Nasdaq Composite, each posting their biggest weekly percentage gains since June, according to Dow Jones Market Data.

Still, US stocks are in a bear market.

“We have been advising our advisors and clients to remain cautious for the rest of this year,” leaning on quality assets while staying focused on the US and considering defensive areas such as healthcare that can help mitigate the risk, said Saglimbene of Ameriprise. “I think volatility is going to be high.”

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