What’s next for the stock market as the Federal Reserve heads for a ‘hawk peak’

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Investors will be watching another indicator of US inflation in the week ahead after the stock market was rocked by the Federal Reserve stepping up its hawkish tone and suggesting big interest rate hikes are coming to rein in an economy overheated.

“We’re probably seeing a spike in hawkishness 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 so high and so far only one 25 basis point increase under its belt.”

Fed Chairman Jerome Powell said April 21 at a roundtable hosted by the International Monetary Fund in Washington that the central bank is not “counting” on inflation that peaked in March. “It’s appropriate in my opinion 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 larger moves in the coming month.

U.S. stocks closed sharply lower after his remarks 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, portfolio manager at FLPutnam Investment Management Co.

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

The central bank wants to stage a soft landing for the US economy, aiming to tighten monetary policy to tackle 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 precarious position,” wrote Osterweis Capital Management portfolio managers Eddy Vataru, John Sheehan and Daniel Oh, in a report on their 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 shrinking its balance sheet to raise longer-maturity rates and contain inflation, but “unfortunately, the implementing a two-pronged quantitative tightening plan requires a level of finesse that the Fed is not known for,” they wrote.

They also raised concerns about the recent brief inversion of the Treasury yield curve, where short-term yields exceeded long-term yields, calling it “a rarity for this stage of a tightening cycle.” This reflects “a policy error”, they say, which they described as “leaving rates too low for too long, then potentially rising too late, and probably too much”.

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

“There’s something about the idea of ​​front-loading,” Powell remarked during the April 21 roundtable. James Bullard, chairman of the Federal Reserve Bank of St. Louis, said on April 18 that he would not rule out a sharp rise. by 75 basis points, although that is not its base case, the Wall Street Journal reported.

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

“It’s very likely that the Fed will move 50 basis points in May”, but the stock market is having “a little more difficulty digesting” the idea that half-point increases could also occur in June and July, Anthony said. Saglimbene, global market strategist at Ameriprise Financial, in a phone interview.

The Dow DJIA,
-2.82%
and S&P 500 SPX,
-2.77%
each fell nearly 3.0% on Friday, while the Nasdaq Composite COMP,
-2.55%
fell 2.5%, according to Dow Jones Market Data. All three major benchmarks ended the week with losses. The Dow Jones fell for a fourth straight week, while the S&P 500 and Nasdaq each saw a third straight week of declines.

The market is “returning to this idea that we’re going to move to a more normal fed funds rate much faster than we probably thought” a month ago, according to Saglimbene.

“If it’s a spike in warmongering and they’re pushing the lag really hard,” Violin said, “maybe they’re buying themselves more flexibility later in the year as they start to see the impact of a very quick return to neutral.”

A faster pace of interest rate hikes by the Fed 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 had not estimated the investors, according to Saglimbene. The rate, now between 0.25% and 0.5%, is considered “neutral” when it neither stimulates nor restricts economic activity, he said.

Meanwhile, investors fear the Fed could shrink its balance sheet by about $9 trillion as part of its quantitative tightening program, according to Violin. The central bank is aiming for a faster pace of reduction compared to its last quantitative tightening effort, which rocked markets in 2018. The stock market plunged around Christmas that year.

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

Saglimbene said he expects investors to “look beyond” quantitative tightening until the Fed’s monetary policy turns tight and economic growth slows “more materially.”

The last time the Fed attempted to unwind its balance sheet, inflation was not an issue, SEI’s Solloway said. Now “they are watching” high inflation and “they know they have to tighten things up.”

Lily: US inflation rate jumps to 8.5%, CPI shows, as rising gasoline prices hit consumers

At this point, a more hawkish Fed is “deserved and necessary” to combat the soaring cost of living in the United States, said Luke Tilley, chief economist at Wilmington Trust, in a telephone 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 hikes “after doing that frontloading.”

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

Next week, investors will be watching March inflation data closely, as measured by the Personal Consumption Expenditures Price Index. Solloway expects PCE inflation data, to be released by the US government on April 29, to show an increase in the cost of living, in part because “energy and food prices increase sharply.

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

Ameriprise’s Saglimbene said he will keep an eye on quarterly corporate earnings reports next week from the “consumer-facing” and megacap technology companies. “They’re going to be ultra-important,” he said, quoting Apple Inc. AAPL,
-2.78%,
Meta Platforms Inc. FB,
-2.11%,
PepsiCo Inc.PEP,
-1.54%,
Coca-Cola Co. KO,
-1.45%,
Microsoft Corp. MSFT,
-2.41%,
General Motors Co. GM,
-2.14%
and Google’s parent company Alphabet Inc. GOOGL,
-4.15%
as examples.

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

Meanwhile, FLPutnam’s Violin said he was “pretty comfortable staying fully invested in the stock markets.” He cited a low risk of recession, but said he preferred companies with “here and now” cash flows as opposed to more growth-oriented companies with earnings expected in the future. Violin also said he likes companies ready to benefit from rising commodity prices.

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

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