Why stock investors keep falling for Fed ‘pivot’ talk — and what it’ll take to put a bottom

By Joseph Adinolfi

The pace of Fed rate hikes often doesn’t match what investors or the central bank expect

Should you buy stocks now or wait?

Market timing has been a nagging question for investors ever since stocks began their roughly 25% decline in January this year. The correct answer likely depends on whether or not the Federal Reserve follows through on its intention to raise its benchmark interest rate to 4.5% or more, as market-based indicators and the latest batch of Fed projections.

Global markets are nervous about the possibility of an emerging market crisis resulting from higher interest rates and a US dollar at its highest level in 20 years, or a housing market collapse due of rising mortgage rates, or the collapse of a financial institution due to the worst bond market chaos in a generation.

See: A raging US dollar wreaks havoc on the markets: why it’s so hard to stop

Fears that the Fed could cause a “break” in the global economy or the financial system have prompted some to wonder whether the Fed can succeed in boosting inflation by raising interest rates at the most aggressive pace in decades. decades without causing collateral damage.

The Fed’s efforts are already upsetting the markets almost daily.

Continued market volatility makes it difficult to determine when buying opportunities might arise, said Bill Sterling, global strategist at GW&K Investment Management.

The peak in interest rates matters for equities

A look back at how the Fed has handled monetary policy relative to its own projections offers good reason to be skeptical about expectations about when the Fed will return to easing monetary policy.

It is important to remember that stocks have often reacted positively when the Fed has returned to lowering interest rates. Dating back to August 1984, the S&P 500 index has risen on average more than 17% in the 12 months (see chart) since a peak in the fed funds rate range, according to Sterling at GW&K and data from the Fed.

The chart also shows that the Nasdaq Composite and the Dow Jones Industrial Average rose sharply over the year after the Fed cut interest rates to their highest levels in previous rounds of monetary policy tightening. over the past 40 years or so.

The same goes for bonds, which have historically outperformed after the Fed’s interest rate hike cycle peaked. The pound said yields have historically fallen by, on average, a fifth of their value, in the 12 months since the peak in Fed benchmark rates.

A factor that still differentiates modern times from the persistent inflation of the 1980s is the high level of geopolitical and macroeconomic uncertainty. As Tavi Costa, portfolio manager at Crescat Capital, said, the weakening US economy, along with fears of a crisis erupting somewhere in global markets, complicates the outlook for monetary policy.

But as investors watch markets and economic data, Sterling said “retrospective” metrics like the U.S. Consumer Price Index and Personal Consumption Expenditure Index aren’t as helpful as gauges.” forward-looking”, such as break-even deviations. generated by Treasury inflation-protected securities, or survey data such as the University of Michigan’s Inflation Expectations Indicator.

“The market is caught between these forward-looking and encouraging signs that inflation may come off next year, as seen in the [Treasury inflation-protected securities] returns,” Sterling said.

Stocks kicked off last week and the fourth quarter with a two-day rally after major indexes ended September 30 at their lowest level since 2020. Those gains faded over the week as those responsible for Fed and economic data undermined investor expectations around a potential Fed. “walk away” from its program of aggressive interest rate hikes. Stocks ended the week higher, but with the Dow Jones Industrial Average up just 2% from its September 30 low, while the S&P 500 cut its weekly rise to 1.5% and the Nasdaq Composite rose only 0.7%.

Read: Dashed hopes of a Fed pivot turn into a sense of dread in financial markets

Minneapolis Fed Chairman Neel Kashkari and Fed Governor Christopher Waller said policymakers have no intention of abandoning their interest rate hike plan, in what was just the latest round of hawkish comments from senior Federal Reserve officials.

However, some on Wall Street pay less attention to what senior Fed officials are saying and more attention to market-based indicators such as Treasury spreads, relative movements in sovereign bond yields and spreads. credit institutions, including those of Credit Suisse Inc. (CSGN.EB).

Crescat Capital’s Costa said he sees a growing “disconnect” between the state of the markets and the Fed’s aggressive rhetoric, with the odds of a crash increasing day by day.

For this reason, he is waiting for “the other shoe to drop”, which could be a major turning point for the markets.

He predicts that a blowout will eventually force the Fed and other global central banks to back off on their policy-tightening agenda, as the Bank of England briefly did last month when it decided to inject billions of dollars of liquidity in the gilt market – although the BoE is preparing to continue raising interest rates to fight inflation

See: Bank of England official says $1 trillion in pension fund investments could have been wiped out without intervention

But before that happens, he expects fixed income trading to get as messy as it did in the spring of 2020, when the Fed was forced to intervene to stave off a bond market meltdown in early 2020. the coronavirus pandemic.

“You just have to look at the differential between Treasury yields versus junk bond yields. We haven’t yet seen that spike driven by default risk, which is a sign of a totally dysfunctional market,” he said. said Costa.

See: Cracks in financial markets fuel debate over whether the next crisis is inevitable

A quick glance in the rearview mirror shows that the Fed’s interest rate hike plans rarely go as planned by the central bank. Take the last year for example.

The median projection for the level of the federal funds rate in September 2021 was just 30 basis points a year ago, according to the Fed’s projection survey. It turns out that those projections were off by almost three percentage points.

“Don’t take the Federal Reserve at its word when trying to predict the Fed’s policy direction over the next year,” Sterling said.

Looking forward to next week

Looking ahead to next week, investors will have better insight into the state of the US economy and, by extension, the thinking of the Fed.

U.S. inflation data will be front and center in markets, with September’s consumer price index due on Thursday. On Friday, investors will receive an update from the University of Michigan’s Consumer Sentiment Survey and its Inflation Expectations Survey.

Inflation data will come under scrutiny as investors grapple with signs that the US labor market could indeed start to weaken, according to Krishna Guha and Peter Williams, two US economists at Evercore ISI.

The September jobs report showed on Friday that the US economy gained 263,000 jobs last month, with the unemployment rate falling from 3.55% to 3.7%, but job growth slowed 537,000 in July and 315,000 in August.

But will inflation show signs of peaking or slowing? Many fear that the cuts in crude oil production quotas imposed by OPEC+ earlier this week could drive prices higher later in the year.

Meanwhile, the fed funds futures market, which allows investors to bet on the pace of Fed interest rate hikes, forecasts another 75 basis point hike on November 3.

Beyond that, traders expect the federal funds rate to top out in February or March at 4.75%, according to the Fed’s FedWatch tool.

-Joseph Adinolfi

 

(END) Dow Jones Newswire

10-09-22 0931ET

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