Why do investors fear a full percentage point rate hike from the Fed could “disturb” Wall Street

The Fed has raised interest rates by 75 basis points so far this year. An earlier version of this story stated that she delivered three.

With both US stocks and bonds under pressure on Tuesday, some on Wall Street are arguing that investors are underestimating the possibility of the Federal Reserve’s surprise rate hike by 100 basis points at the conclusion of its two-day policy meeting on Wednesday. .

While Fed fund futures traders overwhelmingly expect a rise of 75 basis points, or 0.75 percentage points, on Wednesday, their concern is that last week’s August CPI print, along with the still-strong labor market, may be He has convinced Federal Reserve Chairman Jerome Powell and other hawks on the Fed’s policy setting committee that they must do more than just stay on track as they struggle to rein in inflation.

Instead, federal policymakers may feel they must act more aggressively.

If that happens, it would be the most aggressive example of Fed tightening since the days of Paul Volcker, who served as Fed chair from 1979 to 1987, following a “jumbo” 75 basis point interest rate hike, and a 50 basis point hike in May. .

We see: Biggest Fed rate hike in 40 years? It could come this week.

Many are concerned that lowering the hammer too hard risks unleashing chaos through the markets by essentially ruling out the possibility of a “soft landing” for the US economy. Others worry more that failure to push markets back now could lead to much worse consequences in the future.

How will the markets react?

Sam Stovall, CFRA’s chief investment strategist, said in a note to clients that a 100 basis point hike would be an “overreaction” by the Fed.

“We believe a 100 basis point hike would upset Wall Street, as it would mean the FOMC overreacts to the data rather than sticking to its game plan, and increases the likelihood that the FOMC will eventually overreact and underestimate the possibility of Achieving a soft landing,” Stovall wrote in a note to clients.

With short-term yields already approaching the pressure point at around 4%, the always carefully designed Fed may not want to risk upsetting the markets in this exhilarating way.

We see: Punishing short-term debt sell-off pushes one price close to ‘magic’ level that ‘scares’ markets

The Fed was sending 75 basis points. “If they go to 100 basis points, I think it would be a shock to the market,” David Rubinstein, the billionaire founder of private equity giant The Carlyle Group, said during an interview Monday with Fox Business.

But assuming the Fed opts for a surprise full percentage point increase, some could envision a scenario where markets actually rally in the face of an even sharper Fed.

“I don’t expect this by any means but I can see a scenario where we get to 100 and the market actually goes up (after the initial flush) based on the idea that the Fed is tearing up first aid rather than slowly removing it,” he said. Matt Tuttle, CEO of Tuttle Capital Management, in an email exchange with MarketWatch.

what is the point?

To be sure, a 100bp rise is still widely seen as a low-probability outcome. The Fed Funds futures markets are currently pricing in a roughly 80% chance of a 75 basis point rise on Wednesday, with the odds of a full move remaining at 20%, according to CME’s FedWatch Tool.

So far, Japanese investment bank Nomura has been one of the few major selling institutions to call for a 100 basis point hike on Wednesday.

But the argument about why the Fed decided to stray from its policy of carefully designed moves has clearly resonated with investors, as evidenced by the fact that many Wall Street strategists have chosen to address probability in the research they provide clients and the media.

In a research note published early Tuesday, Nomura cross asset strategist Charlie McKeligott explained why he thinks markets are “significantly lowering” the potential for a 100 basis point increase.

His reasoning: After the latest batch of economic data, Powell simply can’t risk a positive market reaction on Wednesday, as it will lead to an “unproductive” easing in financial conditions, which occurs when stock prices rise and bond yields fall.

If Powell’s goal is to prevent inflation from becoming entrenched, he must demonstrate that he is “in full contact with the hawks of his only ‘inflation’ mandate,” especially since economic data indicates that the initial wage-price vortex has already begun, he wrote.

“100 basis points are necessary to stay ahead when hitting the demand side of inflation as hard as possible,” McKeligott said in a note to clients on Tuesday.

We see: Can the Fed Tame Inflation Without Further Crushing The Stock Market? What investors need to know.

What is the alternative?

If the Fed were to raise 100 basis points, such a violent move would force markets to consider the possibility that the fed funds rate could hit 5% next year, which would be anathema to the markets and possibly the economy. That’s why Michael Feroli, an economist at JPMorgan Chase & Co., shied away from putting 100 basis points on the underlying issue.

We see: Economists warn US dollar rally is already sending ‘risk signals’

Ferroli wrote in a note to clients published mid-last week.

Instead, as Feroli told JPM clients last week, the US megabank expects the Fed to raise a little more in November, along with an additional 25 basis points increase early next year. An additional 50 basis points of expected tightening should help lift the upper range of the Fed’s rate target to 4.25% by next spring, which is still much higher than many expected in July.

Anything beyond that will depend entirely on the state of the economic data.

“If the labor market is not really cooled by January and February, we look to the committee to continue tightening in 25 basis point moves until that happens,” Feroli added.

US stocks traded lower on Tuesday, with the S&P 500 SPX,
-1.13%And the
Dow Jones Industrial Average DJIA,
-1.01%
and Nasdaq Compound,
-0.95%
strongly in red. Meanwhile, the 2-year Treasury yield TMUBMUSD02Y,
3.962%
It was trading at just under 4%, which is seen as a level that could create more trouble for the stock market.

We see: Why high Treasury yields are a drag on the stock market

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