What to expect from the markets in the next six weeks before the Federal Reserve changes its stance on light money

Federal Reserve Chairman Jerome Powell fired a warning shot over Wall Street last week, telling investors it was time for the financial markets to stand on their own two feet as he worked to tame inflation.

The political update last Wednesday laid the groundwork for the first benchmark rate hike since 2018, presumably in mid-March, and the final end to the central bank’s stance on easy money two years since the start of the pandemic.

The problem is that the Fed strategy also gave investors about six weeks to think about how sharply interest rates could rise in 2022 and how dramatically its balance sheet could shrink when the Fed pulls the trigger to cool inflation, which is at levels that last seen in the early 1980s.

Instead of calming market turmoil, the wait-and-see approach has Wall Street’s “fear meter”, Cboe Volatility Index VIX,
a record 73% increase 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 do not like is uncertainty,” Jason Draho, head of asset allocation Americas at UBS Global Wealth Management, said in a telephone interview, pointing to a sale that has left few corners of the financial markets unscathed in January.

Even with a sharp recovery late Friday, the interest-sensitive Nasdaq Composite Index COMP,
remained in the correction range, defined as a decrease of at least 10% from its most recent record closing. What’s worse, the Russell 2000 index of small capital stocks RUT,
is in a bear market, a fall of at least 20% from the peak on November 8.

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

McClain pointed out that negative performance revealed US corporate bonds of investment grade LQD,
their high-performance HYG,
counterparties and fixed-rate AGGs,
generally to start the year, but also the deeper route in growth and value stocks and losses in the international EEM,

“Everyone is in the red.”

Wait and see

Powell said Wednesday that the central bank “intends” to raise interest rates in March. Decisions on how to significantly reduce its balance sheet by nearly $ 9 trillion will come later and depend on financial data.

“We think in April we will start to see a flood of inflation,” McClain said by telephone, pointing to basic effects or price distortions common during the pandemic that make an annual comparison difficult. “It will provide the ground for the Fed to take a data-dependent approach.”

“But from now until then it will be a lot of volatility.”

‘Peak panic’ about hiking

Because Powell did not directly reject the idea of ​​raising interest rates by 50 basis points or a series of increases at consecutive meetings, Wall Street has slanted towards pricing in a more aggressive monetary policy path than many expected just a few weeks ago.

The CME group’s FedWatch tool on Friday put a chance of almost 33% for the Fed-fund’s interest rate target to climb to the range of 1.25% to 1.50% at the Fed’s meeting in December, through the ultimate path over almost zero is not chopped in stone.

Read: Fed seen as raised interest rates seven times in 2022 or once at each meeting, says BofA

“It’s a bidding war for who can predict the most rate hikes,” Kathy Jones, head of interest rate strategy at the Schwab Center for Financial Research, told MarketWatch. “I think we’re reaching the top panic over Fed rate hikes.”

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

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

Time to play it safe?

“You have the largest provider of liquidity to markets that let go of the gas and quickly go over to hit the brakes. Why increase the risk right now?”

– Dominic Nolan, CEO of Pacific Asset Management

It’s easy to see why some depressed assets may finally end up on shopping lists. Although a tighter policy has not even fully taken hold, some sectors that rose to staggering heights aided by extreme Fed support during the pandemic have not held up well.

“It has to go its own way,” Jones said, noting that it often requires “calling the last pockets out” of foam before markets find the bottom.

Cryptocurrencies BTCUSD,
has been a notable loss in January, along with dizziness around “blank-check” or special-purpose acquisition corporations (SPACs), with at least three scheduled IPOs closed this week.

“You have the largest provider of liquidity to markets that drop on the gas and quickly go over to hit the brakes,” said Dominic Nolan, CEO of Pacific Asset Management. “Why increase the risk right now?”

Once the Fed is able to provide investors with a clearer roadmap for tightening, markets should be able to digest constructively compared to today, he said, adding that the 10-year government yield of TMUBMUSD10Y,
is still an important indicator. “If the curve flattens out significantly when the Fed raises interest rates, it could push the Fed to be more aggressive [tightening] in an attempt to make the curve steeper. “

Rising government interest rates have pushed interest rates in the US investment-grade corporate bond market by almost 3%, and the energy-heavy high-yield component closer to 5%.

“High yields of 5%, for me, are better for the world than 4%,” Nolan said, adding that corporate earnings still look strong even though the peak levels of the pandemic have passed and if economic growth slows from 40 years. highlights.

Draho at UBS, like others interviewed for this story, sees the risk of a recession in the next 12 months as low. He added that while inflation is at its peak in the 1980s, consumer debt levels are also close to the lowest level in 40 years. “The consumer is in strong shape and can afford higher interest rates.”

US economic data to look at on Monday is the Chicago PMI, which limits the wild month. February kicks off with the Ministry of Labor’s job openings and stops on Tuesday. Then its ADP employment report for the private sector and homeownership rate on Wednesday, followed by the big Friday: the jobs report in January.

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