What’s next for the stock market as the Federal Reserve moves toward “peak hawkishness”

Investors will look for a new target for US inflation in the week following the stock market’s surge as the Federal Reserve raised its hawkish tone and hinted that large rate hikes are coming to bring an overheated economy under control.

“We’re probably seeing top hawkishness right now,” James Solloway, chief marketing officer and senior portfolio manager at SEI Investments Co., said in a phone interview. “It’s no secret that the Fed is far behind the curve here, with such high inflation and so far only one increase of 25 basis points below the belt.”

Fed Chairman Jerome Powell said on April 21 during a panel discussion organized by the International Monetary Fund in Washington that the central bank does not “expect”[ads1]; inflation to peak in March. “In my view, it’s appropriate to move a little faster,” Powell said, leaving a 50 basis point rate hike “on the table” for the Fed’s meeting early next month, leaving the door open for more major moves for months to come.

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

“The enormous economic momentum from the recovery from the pandemic is being met with a very rapid shift in monetary policy,” Violin said by telephone. “The markets are struggling, as we all do, to understand what it’s going to be like. I’m not sure anyone really knows the answer.”

The central bank wants to construct a soft landing for the US economy, with the aim of tightening monetary policy to combat the hottest inflation in around 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 weak position,” Osterweis Capital Management’s portfolio managers Eddy Vataru, John Sheehan and Daniel Oh wrote in a report on their prospects for others. quarter for the company’s total return fund.

Osterweiss’ portfolio managers said the Fed could raise the target rate for Fed funds to cool the economy while shrinking the balance sheet to lift longer maturities and curb inflation, but “unfortunately, implementing a two-part quantitative easing plan requires a level of finesse for which the Fed is not known” », They wrote.

They also raised concerns about the Treasury’s short-term inversion curve, where short-term interest rates rose above long-term returns, calling it “a rarity for this stage of a tightening cycle.” It reflects “a policy error”, in their view, which they described as “leaving interest rates too low for too long, and then potentially going too late, and probably too much.”

Last month, the Fed increased its reference rate for the first time since 2018, and increased it by 25 basis points from close to zero. The central bank now seems to be positioning itself to pre-load its interest rate increases with potentially larger increases.

“There’s something in the idea of ​​front-end loading,” Powell noted during the April 21 panel debate. James Bullard, president of the Federal Reserve Bank of St. Louis, said April 18 that he would not rule out a major hike. at 75 basis points, even if it is not his base case, The Wall Street Journal reported.

Read: Fed funds futures traders see 94% probability of 75 basis points Fed increase in June, CME data shows

“It’s very likely that the Fed will move by 50 basis points in May,” but the stock market has “a little harder to digest” the idea that half-point increases could also come in June and July, said Anthony Saglimbene, global market strategist at Ameriprise Financial, in a telephone interview.

and S&P 500 SPX,
each fell nearly 3.0% on Friday, while the Nasdaq Composite COMP,
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 Nasdaq each saw a third consecutive week of declines.

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

“If this is peak hawkishness, and they’re pushing very hard on offset,” Violin said, “they might buy themselves more flexibility later in the year as they begin to see the impact of returning to neutral very quickly.”

A faster rise in interest rates from the Fed could bring federal funds’ interest rates to a “neutral” target level of around 2.25% to 2.5% by the end of 2022, potentially faster 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 limits economic activity, he said.

Meanwhile, investors are worried that the Fed will shrink its balance sheet to around $ 9 trillion under its quantitative easing program, according to Violin. The central bank is aiming for a faster rate of reduction compared with the recent effort for quantitative easing, which fell in the markets in 2018. The stock market plunged around Christmas that year.

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

Saglimbene said he expects investors to largely “overlook” quantitative easing until the Fed’s monetary policy becomes restrictive and economic growth slows “more significantly.”

The last time the Fed tried to settle the balance sheet, inflation was not a problem, said SEI’s Solloway. Now they’re staring at “high inflation and” they know they need to tighten up. ”

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

At this stage, a more hawkish Fed is “deserved and needed” to combat rising cost of living in the United States, said Luke Tilley, chief economist at the Wilmington Trust, in a telephone interview. But Tilley said he expects inflation to slow in the second half of the year, and that the Fed must slow down interest rates “after doing that front-loading.”

The market may have “come a step ahead of expectations for the Fed tightening this year,” says Lauren Goodwin, economist and portfolio strategist at New York Life Investments. The combination of the Fed’s interest rate hikes and quantitative easing program “could lead to tighter market conditions” before the central bank is able to raise interest rates by as much as the market expects in 2022, she said by telephone.

Investors next week will closely monitor inflation data from March, measured by the price index for personal consumption expenditure. Solloway expects that the PCE inflation data, which the US government is scheduled to publish on April 29, will show an increase in the cost of living, partly because “energy and food prices are rising sharply.”

Next week’s financial calendar also includes data on US house prices, sales of new homes, consumer sentiment and consumption.

Ameriprises Saglimbene said he will keep an eye on quarterly business performance reports next week from “consumer-facing” and megacap technology companies. “They’re going to be extremely important,” he said, quoting Apple Inc. AAPL,
Meta Platforms Inc. FB,
PepsiCo Inc. PEP,
Coca-Cola Co. QUEUE,
Microsoft Corp. MSFT,
General Motors Co. GM,
and Google’s parents Alphabet Inc. GOOGL,
as examples.

Read: Investors have just withdrawn $ 17.5 billion from global equities. They are just getting started, says Bank of America.

Meanwhile, FLPutnam’s violin said he is “quite comfortable with being fully invested in the stock markets.” He mentioned the low risk of recession, but said that he prefers companies with cash flows “here and now” as opposed to more growth-oriented companies with expected earnings well into the future. Violin also said he likes companies that are ready to take advantage of higher commodity prices.

“We have entered a more volatile time,” SEIs Solloway warned. “We really need to be a little more careful about how much risk we should take.”

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