By Joy Wiltermuth
Federal Reserve Chairman Jerome Powell fired a warning shot across Wall Street last week, telling investors the time has come for financial markets to stand on their own feet, while he works to tame inflation.
The policy update last Wednesday laid the ground work for the first benchmark interest rate hike since 2018, probably in mid-March, and the eventual end of the central bank’s easy-money stance two years since the onset of the pandemic.
The problem is that the Fed strategy also gave investors about six weeks to brood over how sharply interest rates could climb in 2022, and how dramatically its balance sheet might shrink, as the Fed pulls levers to cool inflation which is at levels last seen in the early 1980s.
Instead of soothing market jitters, the wait-and-see approach has Wall Street’s “fear gauge,” the Cboe Volatility Index /zigman2/quotes/210598281/delayed VIX +0.27% , up a record 73% in the first 19 trading days of the year, according to Dow Jones Market Data Average, based on all available data going back to 1990.
“What investors don’t like is uncertainty,” said Jason Draho, head of asset allocation Americas at UBS Global Wealth Management, in a phone interview, pointing to a selloff that’s left few corners of financial markets unscathed in January.
Even with a sharp rally late Friday, the interest rate-sensitive Nasdaq Composite Index /zigman2/quotes/210598365/realtime COMP -0.30% remained in correction territory, defined as a fall of at least 10% from its most recent record close. Worse, the Russell 2000 index of small-capitalization stocks /zigman2/quotes/210598147/delayed RUT -0.17% is in a bear market , down at least 20% from its Nov. 8 peak.
“Valuations across all asset classes were stretched,” said John McClain, portfolio manager for high yield and corporate credit strategies at Brandywine Global Investment Management. “That’s why there has been nowhere to hide.”
McClain pointed to negative performance nipping away at U.S. investment-grade corporate bonds /zigman2/quotes/206919681/composite LQD +0.49% , their high-yield /zigman2/quotes/204471305/composite HYG -0.07% counterparts and fixed-income /zigman2/quotes/200660887/composite AGG +0.30% generally to begin the year, but also the deeper rout in growth and value stocks, and losses in international /zigman2/quotes/201454250/composite EEM +0.41% investments.
“Every one is in the red.”
Wait-and-see
Powell said Wednesday the central bank “is of a mind” to raise interest rates in March. Decisions on how to significantly reduce its near $9 trillion balance sheet will come later, and hinge on economic data.
“We believe that by April, we are going to start to see a rollover on inflation,” McClain said by phone, pointing to base effects , or price distortions common during the pandemic that make yearly comparison tricky. “That will provide ground cover for the Fed to take a data-dependent approach.”
“But from now until then, it’s going to be a lot of volatility.”
‘Peak panic’ about hikes
Because Powell didn’t outright reject the idea of hiking rates in 50-basis-point increments, or a series of increases at successive meetings, Wall Street has skewed toward pricing in a more aggressive monetary policy path than many expected only a few weeks ago.
The CME Group’s FedWatch Tool on Friday put a near 33% chance on the fed-funds rate target climbing to the 1.25% to 1.50% range by the Fed’s December meeting, through the ultimate path above near- zero isn’t set in stone.
Read : Fed seen as hiking interest rates seven times in 2022, or once at every meeting, BofA says
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