What’s Next for the Stock Market as the Fed Moves Towards “Hardline Peak”?

Investors will be on the lookout for another indicator of US inflation in the week ahead after the stock market was rocked by the Federal Reserve increasing its hawkish tone and suggesting big interest rate hikes are on the way. to control an overheated economy.

“We’re probably seeing a spike in toughness right now,” James Solloway, chief market strategist and senior portfolio manager at SEI Investments Co., said in a phone interview. “It’s no secret that the Fed is way behind the curve here, with inflation this high and only a 25 basis point increase under their belt so far.”

Fed 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 “counting on” inflation to have peaked in March. “From my point of view, it’s appropriate to move a little faster,” Powell said, putting a 50 basis point rate hike “on the table” for the Fed meeting early next month and leaving the door open. to bigger moves in the months ahead.

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

“The tremendous economic momentum from the recovery from the pandemic is being met with a very rapid change in monetary policy,” Violin said by phone. “Markets are struggling, like all of us, to understand how that will play out. I’m not sure anyone really knows the answer.”

The central bank wants to engineer a soft landing for the US economy, aiming to tighten monetary policy to combat the highest inflation in about four decades without triggering a recession.

The Fed “is partly to blame for the current situation, as its extremely accommodative monetary policy over the past year has left it in this very delicate position,” wrote Osterweis Capital Management portfolio managers Eddy Vataru, John Sheehan and Daniel Oh, in a report on his second-quarter outlook for the company’s total return fund.

Portfolio managers at Osterweis said the Fed may raise the target federal funds rate to cool the economy while reducing its balance sheet to raise longer-dated rates and contain inflation, but “unfortunately, implementing an adjustment plan Two-pronged quantitative requires a level of finesse for which the Fed is not known,” they wrote.

They also raised concerns about the recent brief inversion of the Treasury yield curve, where short-term yields rose above long-term yields, calling it “a rarity for this stage of a tightening cycle.” That reflects “a policy mistake,” in their view, which they described as “leaving rates too low for too long and then potentially going up too late, and probably too high.”

Last month, the Fed raised its benchmark interest rate for the first time since 2018, raising it by 25 basis points from almost zero. The central bank now appears to be positioning itself to advance its rate hikes with potentially larger hikes.

“There’s something to the front-loading idea,” Powell said during the April 21 panel discussion. James Bullard, president of the Federal Reserve Bank of St. Louis, said on April 18 that he would not rule out a large increase. of 75 basis points, though that is not his base case, The Wall Street Journal reported.

Read: Fed funds futures traders see a 94% chance of a 75 basis point hike from the Fed in June, CME data shows

“The Fed is very likely to move 50 basis points in May,” but the stock market is having “a little more difficulty digesting” the notion that half-point hikes could also come in June and July, he said. Anthony. Saglimbene, global market strategist at Ameriprise Financial, in a phone interview.

The Dow DJIA,
and S&P 500 SPX,
each fell nearly 3.0% on Friday, while the Nasdaq Composite COMP,
it fell 2.5%, according to Dow Jones Market Data. All three major benchmarks ended the week with losses. The Dow fell for the fourth week in a row, while the S&P 500 and the Nasdaq each experienced a third straight week of declines.

According to Saglimbene, the market is “resetting the idea that we are going to move to a more normal fed funds rate much faster than we probably” thought a month ago.

“If it’s all about aggressive stance, and they push very hard on compensation,” Violin said, “perhaps more flex will be bought later in the year, as they start to see the impact of quickly going back to neutrality.” .

A faster pace of interest rate hikes by the Federal Reserve could bring the fed funds rate to a “neutral” target level of around 2.25% to 2.5% before the end of 2022, potentially sooner than investors had estimated, according to Saglimbene. The rate, now in the range of 0.25% to 0.5%, is considered “neutral” when it neither stimulates nor restricts economic activity, she said.

Investors, meanwhile, are concerned that the Federal Reserve will shrink its balance sheet by about $9 trillion under its quantitative tightening program, according to Violin. The central bank is targeting a faster pace of tapering compared to its last quantitative tightening effort, which rocked markets in 2018. The stock market crashed around Christmas of that year.

“The current anxiety is that we are headed to the same point,” Violin said. When it comes to reducing the balance sheet, “how much is too much?”

Saglimbene said he hopes investors can “look past” quantitative tightening until the Fed’s monetary policy turns tight and economic growth is slowing “more materially.”

The last time the Fed tried to unwind its balance sheet, inflation wasn’t an issue, SEI’s Solloway said. Now they “are looking at” high inflation and “know they have to adjust things.”

Read: US inflation rate jumps to 8.5%, CPI shows, as higher gas prices hit consumers

At this stage, a more aggressive Fed is “worthwhile and necessary” to combat the rising cost of living in the US, Luke Tilley, chief economist at the Wilmington Trust, said in a telephone interview. But Tilley said he expects inflation to ease in the second half of the year, and that the Fed will have to slow its rate hikes “after making that early charge.”

The market may have “got ahead of itself in terms of expectations of the Fed tightening this year,” according to Lauren Goodwin, an economist and portfolio strategist at New York Life Investments. The combination of the Fed’s hike and quantitative tightening program “could cause financial market conditions to tighten” before the central bank can raise interest rates as much as the market expects in 2022, she said by phone.

Investors next week will be watching inflation data for March, as measured by the personal consumption expenditures price index. Solloway expects PCE inflation data, which the US government is due to release on April 29, will show an increase in the cost of living, in part because “energy and food prices are rising sharply.” .

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

Ameriprise’s Saglimbene said he will be keeping an eye on quarterly corporate earnings reports next week from “consumer-facing” and mega-cap tech companies. “They are going to be very important,” he said, citing Apple Inc. AAPL,
Meta Platforms Inc. FB,
pepsico Inc.pep,
Coca-Cola Co. KO,
Microsoft Corp. MSFT,
General Motors Co. GM,
and Google’s parent company, Alphabet Inc. GOOGL,
as examples.

Read: Investors just pulled $17.5 billion out of global stocks. They’re just getting started, Bank of America says.

Meanwhile, FLPutnam’s Violin said he is “pretty comfortable staying fully invested in the equity markets.” He cited the low risk of recession, but said he prefers companies with cash flows “here and now” rather than more growth-oriented companies with earnings expected in the distant future. Violin also said that he likes companies that will benefit from higher commodity prices.

“We have entered a more volatile time,” warned SEI’s Solloway. “We really need to be a little more circumspect about the risk we should be taking.”

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