Why stock market investors fear “something else will break” as the Fed attacks inflation

Some investors are confident the Federal Reserve could tighten monetary policy too much to stave off tepid inflation, as markets await a reading this week from the Fed’s preferred gauge of US cost of living.

“Fed officials have been scrambling to scare investors almost every day lately, saying they will continue to raise the federal funds rate,” the central bank’s benchmark interest rate, “until inflation breaks through,” Yardeni Research said in a note on Friday. The memo says they went “trick or treating” before Halloween as they enter a “dark period” that ends the day after their Nov. 1-2 political meeting.

“Like the entire U.S. Treasury bond market, there’s a fear that something else is going to break down down the road,” Yardeni said.

Treasury yields have risen recently as the Fed’s benchmark interest rate hikes put pressure on the stock market. Their rapid gains were halted on Friday as investors digested reports that the Fed may hold talks that could slightly slow its aggressive rate hikes later this year.

Stocks jumped sharply on Friday as the market weighed what appeared to be a potential start to a change in Fed policy, even as the central bank prepares to continue its path of big rate hikes to curb rising inflation this year.

Stock market reaction to The Wall Street Journal’s report that the central bank will raise the federal funds rate by three-quarters of a percentage point next month and that Fed officials may discuss whether to raise interest rates by half a percentage point in December. Anthony Saglimbene, chief market strategist at Ameriprise Financial, seemed too enthusiastic.

It is “fantasy thinking” that the Fed is heading for a pause in interest rate hikes, as they are likely to leave future rate hikes “on the table,” he said in a phone interview.

“I think they backed themselves into a corner when they cut interest rates to zero all last year,” Saglimbene said. As long as high inflation remains sticky, the Fed will likely continue to raise rates, recognizing that those increases work with a lag — and “could do more harm than they intended” as they try to cool the economy.

“Something in the economy can break down in the process,” he said. “That’s the risk we find ourselves in.”


According to Saglimbene, higher interest rates mean more borrowing costs for companies and consumers, slowing economic growth amid growing fears that the U.S. will face a potential recession next year. According to him, as a result of the Fed’s aggressive interest rate hikes, unemployment may increase, and at the same time, “dislocations in the currency and bond markets” may occur.

US investors have seen such financial market cracks abroad.

The Bank of England recently made a surprise intervention in the UK bond market after government debt yields rose and the British pound weakened amid concerns over a tax cut plan that comes as the Bank of England tightens monetary policy to curb high inflation. Prime Minister Liz Truss resigned after the chaos, just weeks after taking the top job, saying she would leave as soon as the Conservatives held a contest to replace her.

“The experiment is over, if you will,” JJ Kinahan, chief executive of IG Group North America, the parent of online brokerage tastyworks, said in a phone interview. “Now we will get a different leader,” he said. “Normally, you wouldn’t be happy about that, but since the day he came in, his policies have been pretty badly received.”

Meanwhile, the US Treasury market is “fragile” and “susceptible 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 market activity.” calls,” pointing to deteriorating liquidity amid weak demand and “investor risk aversion.”

Read: ‘Fragile’ Treasury market at risk of ‘massive forced selling’ or surprise, says BofA.

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

“While anything seems possible these days, especially the scary scenarios, we would like to note that even if the Fed withdraws liquidity” by raising the Fed funds rate and continuing quantitative tightening, the US is a safe haven in tough times globally. the firm said. In other words, the concept of “no alternative country” to invest in other than the United States can provide liquidity to the domestic bond market, he noted.


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

Ten-year Treasury yields fell just over a basis point to 4,212% on Friday after hitting their highest level since June 17, 2008 on Thursday, according to Dow Jones Market Data.

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

Read: Why should the housing market adjust to double-digit mortgage rates in 2023?

“The market is more or less priced into a mild decline,” Williams said. It would be “a very big recession” if the Fed continued to tighten “while focusing maniacally on unemployment rates” “without paying attention to what’s happening in the real world.”

Investors expect the Fed’s path to unusually large rate hikes this year will eventually lead to a softer labor market and reduce demand in the economy in an effort to curb rising inflation. But the labor market has remained strong so far, 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 was “quite concerned” about the Fed potentially tightening monetary policy too much or raising rates too quickly.

The central bank “told us they were dependent on the data,” he said, but said he was concerned it was relying on data “that goes back at least a month.”

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

Later next week, investors will get a reading from the personal consumption-expenditure-price index, the Fed’s preferred inflation gauge for September. The so-called PCE data will be released before the US stock market opens on October 28.

Meanwhile, corporate earnings results, which have begun to be reported for the third quarter, are also “backward,” Catrambone said. The rising US dollar due to the increase of the Fed’s discount rate creates “headwinds” for US companies with multinational businesses.

Read: Stock market investors are gearing up for the busiest week of the earnings season. Here’s how it stacks up so far.

“Because of the slowness with which the Fed operates, you don’t know you’ve gone too far until it’s too late,” Catrambone said. “That’s what happens when you move at this speed and at this scale,” he said, referring to the central bank’s string of big rate hikes in 2022.

“It’s very easy to tiptoe when you’re raising rates 25 basis points at a time,” Catrambone said.


According to IG’s Kinahan, the Fed in the US is “on a tightrope” as it faces the risks of tightening monetary policy. “We haven’t seen the full impact of what the Fed is doing,” he said.

While the labor market looks strong right now, the Fed is tightening against a slowing economy. For example, existing home sales fell as mortgage rates rose, while the Institute for Supply Management’s manufacturing survey, a barometer of American factories, fell to a 28-month low of 50.9% in September.

Also, problems in financial markets could unexpectedly appear as a ripple effect of the Fed’s monetary tightening, warned Spouting Rock’s Williams. “When the Fed raises interest rates this quickly, the water goes out and you find out who has the bathing suit,” he said.

“You just don’t know who is overstressed,” he said, adding to concerns about the potential for illiquidity to explode. “You only know that when you get a margin call.”

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

Still, US stocks are in a bear market.

“We advise our advisors and clients to be cautious for the rest of this year,” Ameriprise’s Saglimbene said, “while focusing on the U.S., leaning on quality assets and looking at defensive areas like healthcare that can help mitigate risk.” “I think volatility is going to be high.”

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