What’s next for the stock market as the Fed moves toward the height of the peak of hawkishness

Investors will be watching another gauge of inflation in the US this week after the stock market was shaken by the Federal Reserve, which intensified its hawkish tone and signaled that big interest rate hikes are coming to control the overheating economy.

James Solway, chief market strategist and senior portfolio manager at SEI Investments Co. , in a phone interview: “It’s possible that we’re experiencing a hawkish rush right now.” “It’s no secret that the Fed is way behind the curve here, with high inflation and so far a single 25 basis point increase under their belt.”

Federal Reserve Chairman Jerome Powell said on April 21 during a panel discussion hosted by the International Monetary Fund in Washington that the central bank is not “reliant” on inflation after it peaked in March. “It is appropriate in my view to move a little faster,” Powell said, putting a 50bps rate hike “on the table” for the Fed meeting early next month and leaving the door open for more massive moves in the coming months.

US stocks closed sharply lower after his comments and all three major indexes extended their losses on Friday, with the Dow Jones Industrial Average posting its biggest daily percentage drop since late October 2020. Investors are grappling with “very strong forces” in the market, according to Stephen Violin, portfolio manager. At FLPutnam Investment Management Co.

“The massive economic momentum from the pandemic recovery is offset by a very rapid shift in monetary policy,” Kaman said by phone. “Markets are struggling, as we all are, to understand how this happens. I’m not sure anyone really knows the answer.”

The central bank wants to engineer a soft landing for the US economy, with the goal of tightening monetary policy to fight the hottest inflation in nearly four decades without causing a recession.

Osterweis Capital Management portfolio managers Eddie Vattaro, John Sheehan and Daniel Oh, wrote in a report about their second-quarter outlook for the company’s total return fund.

Governor Osterweis said the Fed could raise its target fed funds rate to cool the economy while shrinking its balance sheet to raise longer maturities and contain inflation, but “unfortunately, implementing a two-pronged quantitative tightening plan requires a level of precision about which the Fed is not known.”

They also raised concerns about the recent short inversion of the Treasury yield curve, with short-term yields rising above long-term yields, describing them as “a rarity at this point in the tightening cycle.” This reflects a “policy error” in their eyes, which they describe as “leaving rates too low for too long, and then likely to rise too late, perhaps too much”.

Last month, the Federal Reserve raised its benchmark interest rate for the first time since 2018, raising it by 25 basis points from near zero. The central bank now appears to be in a position to pre-load its rate increases with the possibility of larger increases.

“There is something to the idea of ​​front-loading,” Powell said during a panel discussion on April 21, and James Bullard, president of the Federal Reserve Bank of St. Louis, said on April 18 that he would not rule out a significant 75 basis point increase, although that is not his primary case. , the Wall Street Journal reported.

Read: Federal Reserve fund futures traders show a 94% chance of a Fed hike of 75 basis points in June, CME data shows

“It is very likely that the Fed will move 50 basis points in May,” Anthony said, but the stock market is having “a bit of a hard time absorbing” the idea that half point increases may also come in June and July. Saglimbene, global market strategist at Ameriprise Financial, in a phone interview.

The Dow DJIA,
-2.77%
and the S&P 500 SPX,
-3.63%
Both fell about 3.0% on Friday, while the Nasdaq Composite was down,
-4.17%
It is down 2.5%, according to market data from Dow Jones. All three major indices ended the week with losses. The Dow Jones fell for the fourth consecutive week, while the S&P 500 and Nasdaq witnessed their third consecutive week of decline.

According to Saglimbin, the market is “resetting this idea that we’re going to transition to a normal rate on the fed funds much faster than we thought” a month ago.

“If this is the height of the hawks, and they are pushing hard at first, maybe they will buy themselves more flexibility later in the year when they start to see the effect of a quick return to neutrality,” Kaman said.

An acceleration of interest rate increases by the Federal Reserve could raise the fed funds rate to a “neutral” target level of about 2.25% to 2.5% before the end of 2022, potentially faster than investors had expected, according to Saglimpin. He said the rate, now between 0.25% and 0.5%, is considered “neutral” when it is not stimulating or restricting economic activity.

Meanwhile, investors are concerned that the Fed will shrink its roughly $9 trillion balance sheet under its quantitative tightening program, according to Kaman. The central bank aims to speed up the pace of the cut compared to its recent attempts at quantitative tightening, which rattled markets in 2018. The stock market tumbled at Christmas that year.

“The current concern is that we’re headed to the same point,” Kaman said. When it comes to reducing the balance sheet, “What is too much?”

Saglimpin said he expects investors will probably “look past” too much into quantitative tightening until the Fed’s monetary policy becomes tight and economic growth slows down “more materially”.

SEI’s Solway said the last time the Fed tried to work out its balance sheet, inflation wasn’t an issue. Now they are “staring at” high inflation and “knowing they have to tighten things up”.

Read: US inflation jumps to 8.5%, CPI shows, as rising gas prices slam consumers

At this point, “the Fed deserves the toughest and most necessary” to combat the sudden rise in the cost of living in the United States, Luke Tilly, chief economist at the Wilmington Trust, said in a phone interview. But Tilley said he expects inflation to ease in the second half of the year, and the Fed will have to slow the pace of its rate increases “after doing that preload”.

The market may have “outperformed itself in terms of expectations for Fed tightening this year,” says Lauren Goodwin, economist and portfolio strategist at New York Live Investments. She said by phone that the combination of the Fed’s rate hike program and quantitative tightening “could cause a tightening of financial conditions in the market” before the central bank can raise interest rates as much as the market expects in 2022.

This week, investors will be watching closely the inflation data for March, according to the Personal Consumption Price Index and expenditures. Solway expects personal consumption expenditures inflation data, which the US government is due to release on April 29, to show a rise in the cost of living, in part due to “sharply rising energy and food prices.”

This week’s economic calendar also includes data on US home prices, new home sales, consumer confidence and consumer spending.

Ameriprise’s Saglimbin said he will be watching this week’s quarterly corporate earnings reports from “consumer-facing” tech companies and big tech companies. He said, citing Apple Inc. AAPL, “They Will Be Very Important”
-3.66%And
Meta Platforms Inc. FB,
-2.56%And
PepsiCo Inc. PEP
-3.26%And
The Coca-Cola Co.,
-2.39%And
Microsoft Corp. MSFT,
-4.18%And
General Motors General Motors,
-2.17%
and Alphabet Inc.’s subsidiary of Google, GOOGL,
-3.72%
as examples.

Read: Investors just pulled $17.5 billion from global stocks. Bank of America says they are just getting started.

Meanwhile, FLPutnam’s violin said he was “very comfortable staying fully invested in the stock markets.” He cited lower recession risks but said he preferred companies with cash flow “here and now” rather than companies with more growth trends with earnings far into the future. Alkman also said he likes companies that are preparing to take advantage of higher commodity prices.

“We have entered a more volatile time,” SEI’s Solway warned. “We really need to be a little more careful with how much risk we have to take.”

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