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

Some investors fear the Federal Reserve is over-tightening monetary policy in its bid to tame hot inflation as markets look forward to a reading this coming week of the Fed’s preferred measure of the cost of living in the US.

“Fed officials have been trying almost every day to scare investors into speeches declaring that they will continue to raise Federal Funds interest rates,” the central bank’s benchmark rate, “until inflation breaks,” Yardeni Research said. in a note Friday. The memorandum suggests they were going trick-or-treating for Halloween, as they have now entered their “blackout period” ending the day after the close of their November 1-2 policy meeting.

“The growing fear is that something else will break along the way, like the entire US Treasury market,” Yardeni said.

Treasury yields have soared recently as the Fed raised its benchmark interest rate and put pressure on the stock market. Their soaring came to a halt on Friday, as investors digested reports that the Fed could debate a somewhat slowing aggressive rate hike late this year.

Shares rose sharply on Friday as the market weighed in on what was seen as a possible start to a shift in Fed policy, even as the central bank appeared to continue a path of large rate hikes this year to curb rising inflation.

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The stock market’s response to The Wall Street Journal report that the central bank appears poised to raise Fed Funds interest rates by three-quarters of a percentage point next month — and that Fed officials can debate a half-point hike in December — seemed overly excited for Anthony Saglimbene, chief market strategist at Ameriprise Financial.

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

“I think they cornered themselves when they left interest rates at zero all year,” while buying bonds under so-called quantitative easing, Saglimbene said. As long as high inflation remains sticky, the Fed is likely to continue raising interest rates, while acknowledging that those hikes are working with a lag — and “could do more damage than they want” by trying to cool the economy.

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

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

US investors have seen such cracks in the financial markets abroad.

The Bank of England recently made a surprising intervention in the UK bond market after yields on its government debt rose and the British pound fell amid concerns over a tax cut that emerged as the UK 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 holds a competition to replace her.

“The experiment is over, if you will,” JJ Kinahan, chief executive officer of IG Group North America, the parent company 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 came her policy has been pretty badly received.”

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Meanwhile, the US treasury market is “fragile” and “vulnerable to shocks,” Bank of America strategists warned in an Oct. 20 BofA Global Research report. They expressed concern that the treasury market could be “one shock away from the functioning of the market challenges”, pointing to deteriorating liquidity amid weak demand and “increased risk aversion among investors”.

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

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

“While anything seems possible these days, especially in terrifying scenarios, we would like to point out that even as the Fed is withdrawing liquidity” by raising Fed Funds rates and continuing quantitative tightening, the US is a safe haven in tough times worldwide, the firm said. In other words, the idea that “there is no other country” to invest in but the US can provide liquidity to the domestic bond market, the note says.


“I just don’t think this economy is working” as the 10-year Treasury TMUBMUSD10Y yield,
note is approaching 5%, Rhys Williams, chief strategist at Spouting Rock Asset Management, said by phone.

Ten-year Treasury yields fell just over one basis point to 4.212% on Friday, according to Dow Jones Market Data, after rising to the highest level since June 17, 2008, based on 3:00 p.m. Eastern Time.

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

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

Investors expect that the path of unusually large rate hikes by the Fed this year will eventually lead to a weaker labor market, which will slow demand in the economy as a result of its efforts to curb rising inflation. But the labor market has remained strong so far, with a record low unemployment rate of 3.5%.

George Catrambone, head of Americas Trading at DWS Group, said in a telephone interview that he is “fairly concerned” about the possible tightening of monetary policy by the Fed or raising interest rates too quickly.

The central bank “told us they rely on data,” he said, but expressed concern that it relies on data that “looks back at least a month,” he said.

For example, the unemployment rate is a lagging economic indicator. The protective component of the consumer price index, a measure of U.S. inflation, is “sticky, but also very lagging,” Catrambone said.

At the end of next week, investors will get a reading of the personal consumer spending price index, the Fed’s preferred inflation index, for September. The so-called PCE data will be released before the US stock market opens on October 28.

Meanwhile, company results, reported for the third quarter, are also “looking backwards,” Catrambone said. And the US dollar, which has risen as the Fed raises interest rates, is creating “headwinds” for US companies with multinational corporations.

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“Because of the slowdown with the Fed, you don’t know you’ve gone too far until it’s too late,” Catrambone said. “This is what happens when you move with such speed but also with such magnitude,” he said, referring to the central bank’s series of major rate hikes in 2022.

“It’s a lot easier to be on your toes if you raise interest rates by 25 basis points at a time,” Catrambone says.


According to IG’s Kinahan, the US Fed is on a ‘trailing tightrope’ as it risks tightening monetary policy. “We have not yet seen the full effect of what the Fed has done,” he said.

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

Also, problems in the financial markets could unexpectedly emerge as a ripple effect of the Fed’s monetary tightening, warned Williams of Spouting Rock. “Every time the Fed raises interest rates this fast, the water falls out and you know who has the bathing suit” — or not, he said.

“You just don’t know who’s overextended,” he said, worrying about the potential for explosions of illiquidity. “You don’t know that until you get that margin call.”

US stocks closed sharply higher on Friday, with the S&P 500 SPX,
Dow Jones Industrial Average DJIA,
and 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 remain cautious for the remainder of this year,” said Saglimbene of Ameriprise. “I think volatility will be high.”


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