Why investors fear a one percentage point Fed rate hike would ‘discourage’ Wall Street

Why investors fear a one percentage point Fed rate hike would ‘discourage’ Wall Street

The Fed has made two rate hikes of 75 basis points so far this year. An earlier version of this story said it had produced three.

With both US stocks and bonds under pressure on Tuesday, some on Wall Street are arguing that investors are underestimating the possibility that the Fed could implement a surprise 100 basis point rate hike at the end of its two-day policy meeting on Wednesday. .

While futures traders in the Fed funds overwhelmingly anticipate a rise of 75 basis points, or 0.75 percentage point, on Wednesday, their concern is that last week’s consumer price index imprint in August, coupled with the still robust labor market Fed chairman may have convinced Jerome Powell and other hawks on the Fed’s policy-making committee that they need to do more than just stay on track as they struggle to curb inflation.

Instead, Fed policymakers may feel they need to step up their actions.

Should this happen, it would be the most aggressive example of Fed tightening since the days of Paul Volcker, who chaired the Fed from 1979 to 1987, just after two 75 basis point “jumbo” rate hikes, and a rise of 50 basis points in May.

To see: The biggest Fed rate hike in 40 years? It could come this week.

Many fear that taking the hammer down so forcefully would risk unleashing a pandemonium in the markets by essentially taking off the likelihood of a “soft landing” for the US economy. Others are more concerned that if we don’t get the markets on track now, it could have much worse consequences in the long run.

How would markets react?

Sam Stovall, chief investment strategist at CFRA, said in a note to clients that an increase of 100 basis points would be an “overreaction” from the Fed.

“We think a 100 bps surge would make Wall Street jittery, because it would imply that the FOMC is overreacting to the data rather than sticking to its game plan, and it would increase the likelihood that the FOMC will end up over-tightening and the possibility of achieving a soft landing,” Stovall wrote in a note to customers.

With short-term yields already approaching the pressure point of around 4%, the always carefully choreographed Fed may not want to risk disrupting markets in such a light-hearted manner.

To see: A punishing sell-off in short-term debt pushes one rate near the ‘magic’ level that ‘frightens’ the markets

“The Fed is telegraphing 75 basis points. If they went to 100 basis points, I think it would be shocking for the market,” David Rubenstein, the billionaire founder of private equity giant Carlyle Group, said during a Monday interview with Fox Business.

But assuming the Fed opts for a surprise full percentage point hike, some can envision a scenario where markets actually recover in the face of a tighter Fed.

“I’m not predicting this by any means, but I could see a scenario where we get to 100 and the market actually recovers (after the first flush) based on the idea that the Fed is breaking down the bandage rather than slowly removing it, said Matt Tuttle, CEO of Tuttle Capital Management, in an email exchange with MarketWatch.

What’s the point?

To be sure, a 100 basis point increase is still widely seen as a low probability outcome. The futures markets of the Fed funds currently estimate about an 80% chance of a 75 basis point gain on Wednesday, with a full percentage point chance of moving at 20%, according to the CME’s FedWatch tool.

So far, Japanese investment bank Nomura has been one of the few major sell-side institutions to propose a 100 basis point hike on Wednesday.

But the argument as to why the Fed might decide to deviate from its policy of carefully choreographed moves has clearly resonated with investors, evidenced by the fact that so many Wall Street strategists have chosen to tackle the possibility in the research they provide to customers and the media .

In a research paper published early Tuesday, Nomura’s cross-asset strategist Charlie McElligott explained why he believes markets are “significantly underpriced” at the prospect of a 100 basis point gain.

His reasoning: After the latest set of economic data, Powell simply cannot risk a positive market reaction on Wednesday, as that would lead to a “counterproductive” easing in financial conditions, which happens when stock prices rise and bond yields fall.

If Powell’s goal is to prevent inflation from becoming entrenched, he must show that he is “fully dialing in to his lone ‘inflation’ mandate, especially as the economic data suggests that an incipient wage-price spiral is already unfolding. McElligott wrote.

“100 bps is a necessity to stay ahead of the curve in hitting the demand side of inflation as hard as possible,” McElligott said in a note to customers on Tuesday.

To see: Can the Fed tame inflation without further crushing the stock market? What investors need to know.

What is the alternative?

If the Fed passes a 100 basis point hike, such an aggressive move would force markets to consider the possibility that Fed Funds interest rates could exceed 5% next year, horrifying the markets and perhaps the economy. economy. This is why economist Michael Feroli of JPMorgan Chase & Co. shy away from using 100 basis points as a base case.

To see: Rising US dollar is already sending ‘danger signals’, economists warn

“We think the probability of a 100 basis point displacement – although certainly not zero – is less than a third … good drivers do not increase their speed as they get closer to their destination,” Feroli wrote in a note to customers published in mid last week.

Instead, as Feroli informed JPM’s customers last week, the US megabank expects the Fed to implement a slightly larger rate hike in November, along with an additional 25 basis point hike early next year. The additional 50 basis points from the expected tightening would help push the upper bound of the Fed’s rate target to 4.25% by next spring, which is still much higher than many had expected in July.

Anything beyond that will depend entirely on the state of economic data.

“If the labor market does not cool significantly by January-February, we want the committee to continue the tightening in 25 basis point increments until that happens,” Feroli added.

US stocks were trading lower Tuesday, with the S&P 500 SPX,
-1.13%,
the Dow Jones Industrial Average DJIA,
-1.01%
and Nasdaq Composite COMP,
-0.95%
firmly in red. Meanwhile, the 2-year Treasury yield TMUBMUSD02Y,
3.950%
traded at just under 4%, seen as a level that could cause further headaches for the stock market.

To see: Why rising government bond yields are holding back the stock market?

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