With both US stocks and bonds under pressure on Tuesday, some on Wall Street argue that investors are underestimating that the Fed could deliver a surprise 100 basis point interest rate hike at the end of its two-day policy meeting on Wednesday.
While futures traders are expecting a hike of 75 basis points, or 0.75 percentage points, on Wednesday, their concern is that last week’s August consumer price index print, along with the still labor market strong, to be Fed Chairman. Jerome Powell (and other hawks on the Fed’s policy-setting committee) that they need to do more than stay the course as they struggle to contain inflation.
Instead, Fed policymakers may feel the need to act more forcefully.
If that were to happen, it would be the most aggressive case of Fed tightening since the days of former Fed Chairman Paul Volcker, coming on the heels of three “jumbo” rate hikes of 75 basis points.
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Many worry that bringing the hammer down so forcefully would risk unleashing pandemonium across the markets and essentially take the prospect of a “soft landing” for the US economy off the table. Others are more concerned that a failure to bring markets to heel now could threaten far worse consequences.
How would markets work?
Sam Stovall, chief investment strategist at CFRA, said in a note to clients that a 100 basis point hike would be an “overreaction” on the part of the Fed.
“We think a 100 bps hike would upset Wall Street, as it would suggest that the FOMC is overreacting to the data rather than sticking to its game plan, and would increase the likelihood that the FOMC will eventually cut and that it would reduce the possibility of achieving. soft landing,” Stovall wrote in a note to clients.
With short-term yields already approaching pressure of around 4%, the ever-cautious Fed may not want to risk disrupting markets in such an alarming way.
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“The Fed is telegraphing 75 basis points. If they went to 100 basis points, I think it would be scary for the market,” said David Rubenstein, founder of private equity giant Carlyle Group, during an interview Monday with Fox Business.
But assuming the Fed opts for an unexpected full-percentage rate hike, some can imagine a scenario where markets will face more tightening.
“Not to predict this by any means but I could see a scenario where we get to 100 and the market really rallies (after the initial flush) based on the idea that the Fed is ripping off the Band-Aid rather than slowly removed,” said Matt Tuttle, CEO of Tuttle Capital Management, in an email exchange with MarketWatch.
What is the point?
To be sure, a 100 basis point hike is still widely seen as a low probability. Fed funds futures markets are currently pricing in about 80% odds of a 75 basis point hike on Wednesday, while odds on a full percentage point move remain at 20%, according to the CME’s FedWatch tool.
So far, Japanese investment bank Nomura was one of the few major selling institutions to call for a 100 basis point hike on Wednesday.
But the argument over why the Fed might decide to depart from its policy of carefully choreographed moves has caught on with investors, and the fact that so many Wall Street strategists have chosen to address the feasibility in the research they provide to clients and the media. .
In a research note published early Tuesday, Nomura cross-asset strategist Charlie McElligott explained why he believes markets are “significantly underpriced” for a 100 basis point hike.
His reasoning: After the latest batch of economic data, Powell cannot risk a positive market reaction on Wednesday, as it would lead to a “counterproductive” easing of financial conditions, which occurs when stock prices rise and yields fall bonds.
If Powell aims to stop inflation from spiraling, he must demonstrate that he is “fully dialed back on his single ‘inflationary’ mandate,” especially since the economic data suggest that an initial wage-price spiral is already taking effect, McElligott. write.
“100bps is necessary to stay ahead of the demand side of hitting inflation as hard as possible,” McElligott said in a note to clients on Tuesday.
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What is the alternative?
If the Fed delivers a 100 basis point hike, such an aggressive move would force markets into the possibility that the fed funds rate could top 5% next year, which would be anathema to markets and possibly the economy. That is why the economist JPMorgan Chase & Co. Michael Feroli after stopping him from making 100 basis points.
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“We think the odds of a 100 basis point move – while certainly not zero – are lower than a third … good drivers don’t increase their speed as they get closer to their destination,” wrote Feroli in a note to clients published in the middle of last week.
Instead, as Feroli told JPM clients last week, the US megabank expects the Fed to deliver a slightly larger hike in November, as well as an additional 25 basis point hike early in the year. next. The additional 50 basis points of expected tightening would help bring the upper band of the Fed’s interest rate target to 4.25% by next spring, which is still much higher than many expected back in a month July.
Anything after that will depend entirely on the state of the economic data.
“If the labor market is not cooling materially by Jan-Feb, we want the Committee to continue to tighten with 25bp moves until that happens,” Feroli added.
US stocks were trading lower on Tuesday, with the S&P 500 SPX,
out by more than 1% and the Dow Jones Industrial Average DJIA,
down nearly 400 points going into midday. The Nasdaq Composite COMP,
he was also firmly in the red. Meanwhile, the 2-year Treasury yield TMUBMUSD02Y,
traded at just under 4%, which is seen as a level that could cause more headaches for the equity market.
Look: Why rising Treasury yields are a drag on the stock market