What to expect from the markets over the next six weeks, before the Federal Reserve revamps its easy money policy

Federal Reserve Chairman Jerome Powell fired a warning shot across Wall Street last week, telling investors that now was the time for financial markets to stand tall as he struggled to rein in inflation.

Last Wednesday’s policy update set the stage for the first benchmark interest rate hike since 2018, likely in mid-March, and the eventual end of the bank’s easy money stance. center two years after the start of the pandemic.

The problem is that the Fed’s strategy has also given investors about six weeks to ruminate on just how high interest rates might rise in 2022 and how much its balance sheet might shrink, as the Fed pulls levers to cool down. inflation which is at levels last seen in the early 1980s.

Instead of easing market jitters, the wait-and-see approach uses Wall Street’s “fear gauge,” the Cboe VIX volatility index,
up a record 73% in the first 19 trading days of the year, according to the Dow Jones Market Data Average, based on all available data dating back to 1990.

“What investors don’t like is uncertainty,” Jason Draho, head of Americas asset allocation at UBS Global Wealth Management, said in a phone interview, pointing to a selloff. which spared some corners of the financial markets in January.

Even with a strong rally on Friday evening, the interest rate-sensitive Nasdaq COMP composite index,
remained in correction territory, defined as a drop of at least 10% from its most recent all-time high close. Worse, the Russell 2000 Index of RUT Small Cap Stocks,
is in a bear market, down at least 20% from its November 8 peak.

“Valuations across all asset classes have been stretched,” said John McClain, portfolio manager for high yield and corporate credit strategies at Brandywine Global Investment Management. “That’s why there was nowhere to hide.”

McClain pointed out that the negative performance stifled US investment grade LQD corporate bonds,
their high yield HYG,
counterparties and bond AGG,
generally at the beginning of the year, but also the deeper rout of growth and value stocks, and the losses of the international EEM,

“Everyone is in the red.

wait and watch

Powell said Wednesday that the central bank “is OK” with raising interest rates in March. Decisions on how to significantly reduce its nearly $9 trillion balance sheet will come later and depend on economic data.

“We think by April we’re going to start to see a reversal in inflation,” McClain said by phone, pointing to base effects or price distortions common during the pandemic that make annual comparison tricky. “This will provide ground cover for the Fed to take a data-dependent approach.”

“But until then there will be a lot of volatility.”

“Peak panic” about hikes

Because Powell did not outright reject the idea of ​​a rate hike in 50 basis point increments, or a series of increases in successive meetings, Wall Street veered toward more monetary policy. aggressive than many expected just a few weeks ago. .

CME Group’s FedWatch tool Friday put a nearly 33% chance that the federal funds rate target will climb into the 1.25% to 1.50% range by the Fed’s December meeting, through the ultimate path above near zero is not set in stone.

Read: The Fed is considered to raise interest rates seven times in 2022, or once at each meeting, according to BofA

“It’s a bidding war over who can predict the most rate hikes,” Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, told MarketWatch. “I think we are reaching a peak of panic over Fed rate hikes.”

“We have three rate hikes planned, it depends on how quickly they decide to use the balance sheet to tighten,” Jones said. Schwab’s team has set July as the starting point for an annual drawdown of about $500 billion on Fed holdings in 2022, with a $1 trillion cut as an outside possibility.

“There’s a lot of short-term paper on the Fed’s balance sheet, so they could pull out a lot of it very quickly, if they wanted to,” Jones said.

Time to play it safe?

“You’ve got the biggest liquidity provider to the markets letting off the gas and moving quickly to the brakes. Why increase the risk now? »

— Dominic Nolan, Managing Director of Pacific Asset Management

It’s easy to see why some downed assets might end up on shopping lists. Although policy tightening hasn’t even fully kicked in yet, some sectors that have soared to dizzying heights, aided by extreme Fed support during the pandemic, have not held up well.

“It’s got to run its course,” Jones said, noting that you often have to “squeeze the last pockets” of foam before markets bottom.

Cryptocurrencies BTCUSD,
were a notable casualty in January, as well as giddiness around “blank checks” or special purpose acquisition companies (SPACs), with at least three IPOs slated for this week.

“You’ve got the biggest liquidity provider to the markets letting off the gas and moving quickly to the brakes,” said Dominic Nolan, managing director of Pacific Asset Management. “Why increase the risk now? »

Once the Fed is able to provide investors with a clearer tightening roadmap, markets should be able to digest constructively from today, he said, adding that the yield 10-year Treasury TMUBMUSD10Y,
remains an important indicator. “If the curve flattens significantly as the Fed hikes rates, that could push the Fed to be more aggressive. [tightening] in order to accentuate the curve.

Rising Treasury yields pushed yields in the US investment-grade corporate bond market closer to 3%, and the energy-heavy high-yield component closer to 5%.

“A high return at 5%, to me, is better for the world than 4%,” Nolan said, adding that corporate earnings still look strong even though pandemic peak levels have passed and if economic growth moderates from the age of 40. tops.

Draho at UBS, like others interviewed for this story, views the risk of a recession over the next 12 months as low. He added that while inflation is at 1980s highs, consumer debt levels are also near 40-year lows. “The consumer is in great shape and can afford higher interest rates.”

The US economic data to watch on Monday is the Chicago PMI, which capped the wild month. February kicks off with Department of Labor job postings and leaves on Tuesday. Then its ADP report on private sector employment and the homeownership rate on Wednesday, followed by the big Friday: the January employment report.

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