Why investors fear a one percentage point Fed rate hike will disrupt Wall Street

Why investors fear a one percentage point Fed rate hike will disrupt Wall Street

The Fed has made two 75 basis point interest rate hikes so far this year. An earlier version of this story said she delivered three.

As U.S. stocks and bonds come under pressure on Tuesday, some on Wall Street say investors are underestimating the possibility that the Fed could offer a surprise 100 basis point interest rate hike at the close of its meeting. two-day policy on Wednesday. .

With fed funds futures traders overwhelmingly pricing in a 75 basis point or 0.75 percentage point rise on Wednesday, their concern is that last week’s August consumer price index, coupled to the still-robust labor market, was able to convince Fed Chairman Jerome Powell and other hawks on the Fed’s policy-making committee that they need to do more than just stay the course as they struggle to rein in inflation.

Instead, Fed policymakers may think they need to act more forcefully.

If that happens, it would mark the most aggressive example of Fed tightening since the days of Paul Volcker, who chaired the Fed from 1979 to 1987, following two “jumbo” rate hikes of 75 basis points. basis, and an increase of 50 basis points in May.

See: Biggest Fed rate hike in 40 years? It could happen this week.

Many fear that bringing down the hammer with such force could trigger pandemonium in the markets by essentially removing the likelihood of a “soft landing” for the US economy. Others are more concerned that failing to bring the markets to heel now could lead to far worse consequences in the future.

How would the markets react?

Sam Stovall, chief investment strategist at CFRA, said in a note to clients that a 100 basis point hike would represent an “overreaction” from the Fed.

“We believe a 100 basis point hike would piss off Wall Street, as it would imply the FOMC is overreacting to the data rather than sticking to its game plan, and would increase the likelihood that the FOMC will eventually go down. tighten excessively and reduce the possibility of achieving a soft landing,” Stovall wrote in a note to clients.

With short-term yields already approaching the pressure point around 4%, the ever carefully choreographed Fed might not want to risk upsetting the markets in such a light-hearted way.

See: Sudden sell-off in short-term debt pushes rate near ‘magical’ level that ‘scares’ markets

“The Fed telegraphed 75 basis points. If they were to hit 100 basis points, I think that would be shocking to the market,” David Rubenstein, the billionaire founder of private equity giant Carlyle Group, said in an interview Monday with Fox Business.

But assuming the Fed opts for a surprise one percentage point hike, some may be looking at a scenario in which markets actually rally in the face of a more strident Fed.

“I don’t foresee this by any means, but I could see a scenario where we get 100 and the market rallies (after the first wave) based on the idea that the Fed is ripping the band-aid off instead of slowly removing it. “said Matt Tuttle, CEO of Tuttle Capital Management, in an email exchange with MarketWatch.

What’s the point?

Admittedly, a 100 basis point hike is still widely seen as a low probability outcome. Fed funds futures markets are currently pricing in about an 80% chance of a 75 basis point move higher on Wednesday, with the chance of a full one percentage point move lingering at 20%, according to the tool. WEC’s FedWatch.

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

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

In a research note released early Tuesday, Nomura’s cross-asset strategist Charlie McElligott explained why he thinks markets are “significantly undervaluing” the prospect of a 100 basis point rally.

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

If Powell’s goal is to keep inflation from taking hold, he must demonstrate that he is “completely aware of his sole ‘inflation’ mandate”, especially since economic data suggests that ‘an incipient wage-price spiral is already taking hold, McElligott wrote.

“100 basis points is a necessity to stay ahead of the curve to hit inflation demand as hard as possible,” McElligott said in a note to clients on Tuesday.

See: Can the Fed rein in inflation without further crushing the stock market? What investors need to know.

What is the alternative?

If the Fed proceeds with a 100 basis point hike, such an aggressive move would force markets to price in the possibility of the fed funds rate going above 5% next year, which would be anathema to markets and may -be for the economy. That’s why JPMorgan Chase & Co. economist Michael Feroli was reluctant to make 100 basis points his base case.

See: A rising US dollar is already sending ‘danger signals’, economists warn

“We believe the odds of a 100 basis point move – while certainly not zero – are less than a third…good drivers don’t increase their speed the closer they get to their destination” , wrote Feroli in a note to clients published in the middle of last week.

Instead, as Feroli informed JPM clients last week, the US megabank expects the Fed to make a slightly bigger hike in November, as well as an additional 25 bps hike. baseline early next year. The additional 50 basis points of expected tightening would help bring the upper range of the Fed’s interest rate target down to 4.25% by next spring, which is still much higher than many believe. had planned in July.

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

“If the labor market does not cool noticeably by January-February, we will look for the Committee to continue to tighten in 25 basis point moves until that happens,” Feroli added.

US stocks were trading lower on Tuesday, with the S&P 500 SPX,
-1.13%,
the Dow Jones Industrial Average DJIA,
-1.01%
and Nasdaq Composite COMP,
-0.95%
solidly in the red. Meanwhile, the 2-year Treasury yield TMUBMUSD02Y,
3.970%
was trading at just under 4%, seen as a level that could create more headaches for the stock market.

See: Why rising Treasury yields are a drag on the stock market

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