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Why stock market investors fear ‘something else will break’ as the Fed attacks inflation

Some investors are convinced the Federal Reserve may be tightening monetary policy too hard in its bid to curb tepid inflation, as markets look ahead to a reading this coming week from the Fed’s preferred measure of the cost of living in the US

“Fed officials have been scrambling to scare investors almost every day recently in speeches declaring they will continue to raise the federal funds rate,” the central bank’s benchmark interest rate, “until inflation breaks,” Yardeni Research said in a note Friday. The note suggests they went “trick-or-treating” before Halloween, as they have now entered the “blackout period” that ends the day after the conclusion of the November 1-2 policy meeting.

“The growing fear is that something else will break along the way, like the entire U.S. Treasury market,”[ads1]; Yardeni said.

Treasury yields have recently risen as the Fed raises the benchmark interest rate, which puts pressure on the stock market. On Friday, their rapid ascent stalled as investors digested reports suggesting the Fed may discuss slowing aggressive rate hikes late this year.

Stocks jumped sharply on Friday as the market weighed what was seen as the potential start of a shift in Fed policy, even as the central bank looked set to continue a path of big rate hikes this year to curb soaring inflation.

The stock market’s reaction to The Wall Street Journal’s report that the central bank looks set to raise the Fed funds rate by three-quarters of a percentage point next month — and that Fed officials may debate whether to raise half a percentage point in December — seemed far too enthusiastic for Anthony Saglimbene, market strategist at Ameriprise Financial.

“It’s wishful thinking” that the Fed is headed for a pause in interest rate hikes, as they are likely to leave future rate hikes “on the table,” he said in a telephone interview.

“I think they painted themselves into a corner when they left interest rates at zero all last year” while buying bonds under so-called quantitative easing, Saglimbene said. As long as high inflation remains sticky, the Fed will likely continue to raise interest rates while realizing that those increases work with a lag — and may do “more harm than good” in trying to cool the economy.

“Something in the economy could break in the process,” he said. “That’s the risk we’re in.”


Higher interest rates mean it costs more for companies and consumers to borrow, slowing economic growth amid heightened fears that the US faces a potential recession next year, according to Saglimbene. Unemployment could rise as a result of the Fed’s aggressive rate hikes, he said, while “dislocations in the currency and bond markets” could emerge.

American investors have seen such cracks in financial markets abroad.

The Bank of England recently made a surprise intervention in the UK bond market after interest rates on government debt rose and the British pound sank amid concerns over a tax cut plan that emerged as Britain’s central bank tightened monetary policy to curb high inflation. Prime Minister Liz Truss resigned in the wake of the chaos, just weeks after taking the top job, saying she would leave as soon as the Conservative Party held a contest to replace her.

“The experiment is over, if you will,” JJ Kinahan, CEO of IG Group North America, the parent of online brokerage Tastyworks, said in a telephone interview. “So now we’re going to get another leader,” he said. “Normally you wouldn’t be happy about that, but since the day she arrived, her policies have been pretty badly received.”

Meanwhile, the U.S. financial market is “fragile” and “vulnerable to shocks,” Bank of America strategists warned in a BofA Global Research report dated Oct. 20. They expressed concern that the financial market “could be one shock away from market functioning” challenges,” pointing to weakened liquidity amid weak demand and “increased investor risk aversion.”

Read: ‘Fragile’ financial market at risk of ‘large-scale forced selling’ or surprise leading to collapse, BofA says

“The fear is that a debacle like the recent one in the UK bond market could happen in the US,” Yardeni said in his note on Friday.

“While anything seems possible these days, especially scary scenarios, we would point out that even if the Fed pulls out liquidity” by raising the Fed Funds rate and continuing quantitative easing, the U.S. is a safe haven amid challenging times globally. said firmly. In other words, the notion that “there is no alternative country” to invest in other than the United States could provide liquidity to the domestic bond market, according to the note.


“I just don’t think this economy works” if the yield on the 10-year Treasury TMUBMUSD10Y,
note is starting to approach anywhere near 5%, Rhys Williams, chief strategist at Spouting Rock Asset Management, said by phone.

Ten-year Treasury yields fell a little more than one basis point to 4.212% on Friday, after climbing Thursday to the highest rate since June 17, 2008 based on 3 p.m. ET, according to Dow Jones Market Data.

Williams said he worries that rising financing rates in the housing and auto markets will squeeze consumers, leading to lower sales in those markets.

Read: Why the housing market should prepare for double-digit mortgage rates in 2023

“The market has more or less priced in a mild recession,” Williams said. If the Fed continued to tighten, “without regard to what’s happening in the real world” while “maniacally focused on unemployment rates,” it would be “a very big recession,” he said.

Investors expect the Fed’s path of unusually large interest rate hikes this year to eventually lead to a softer labor market, dampening demand in the economy as they try to curb rising inflation. But the labor market has so far remained strong, with a historically low unemployment rate of 3.5%.

George Catrambone, head of Americas trading at DWS Group, said in a telephone interview that he is “quite concerned” that the Fed will potentially tighten monetary policy too much or raise interest rates too much too quickly.

The central bank “has told us that they are data dependent,” he said, but expressed concern that it is relying on data that is “backward by at least a month,” he said.

Unemployment, for example, is a lagging economic indicator. The refuge component of the CPI, a measure of U.S. inflation, is “sticky, but also particularly sluggish,” Catrambone said.

At the end of this coming week, investors will get a reading from the Personal Consumption Expenditure Price Index, the Fed’s preferred gauge of inflation, for September. The so-called PCE data will be released before the US stock market opens on October 28.

Meanwhile, the company’s earnings results, which have begun to be reported for the third quarter, are also “backward-looking,” Catrambone said. And the US dollar, which has risen as the Fed raises interest rates, is creating “headwinds” for US companies with multinational operations.

Read: Stock investors are preparing for the busiest week of the earnings season. That’s how it is so far.

“Because of the backlog that the Fed operates under, you’re not going to know until it’s too late that you’ve gone too far,” Catrambone said. “This is what happens when you move at such a speed but also such a magnitude,” he said, referring to the central bank’s string of big rate hikes in 2022.

“It’s a lot easier to get around when you’re raising interest rates 25 basis points at a time,” Catrambone said.


In the US, the Fed is on a “tighter leash” as it risks tightening monetary policy, according to IG’s Kinahan. “We haven’t seen the full impact of what the Fed has done,” he said.

While the labor market looks strong for now, the Fed is tightening in a slowing economy. Existing home sales, for example, have fallen as mortgage rates rise, while the Institute for Supply Management’s manufacturing survey, a barometer of US factories, fell to a 28-month low of 50.9% in September.

Also, problems in the financial markets could emerge unexpectedly as a ripple effect of the Fed’s monetary tightening, warned Spouting Rocks Williams. “Any time the Fed raises rates this quickly, that’s when the water goes out and you find out who has the bathing suit” — or not, he said.

“You just don’t know who is handed,” he said, raising concerns about the potential for illiquidity outbreaks. “You only know that when you get that margin call.”

US stocks ended strongly higher on Friday, with the S&P 500 SPX,
Dow Jones Industrial Average DJIA,
and the Nasdaq Composite each scored their biggest weekly percentage gains since June, according to Dow Jones Market Data.

Still, US stocks are in a bear market.

“We have advised our advisors and clients to be cautious throughout the remainder of this year,” leaning on quality assets while staying focused on the U.S. and evaluating defensive areas such as health care that can help mitigate risk, Ameriprise’s Saglimbene said. “I think volatility is going to be high.”

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