Stocks won’t find bottom until Fed nears end of rate-hike cycle, says volatility maven Market Extra

By Vivien Lou Chen

After a huge two-day surge that kicked off the fourth quarter, U.S. equities experienced a late-day rally that fizzled on Wednesday and sent major indexes to a lower finish. And things may not get that much better for stocks anytime soon. Stocks are poised to keep heading lower as earnings “come down hard” and the Federal Reserve raises interest rates until inflation abates, according to volatility expert Harley Bassman. Equities “will not find a bottom” until sometime near the end of the Fed’s rate-hike cycle — which won’t be until next year, based on policy makers’ projections.Bassman is best known as the creator of what’s now called the ICE BofA MOVE Index, Wall Street’s most widely followed measure of fixed-income volatility. That index stood at 152.01 as of Wednesday, according to Refinitiv — triple where it was last September and above the 150 level that Bassman says is unsustainable “if only because human beings cannot tolerate such stress for long periods of time.” It’s periodically surpassed 150 since July.

Bassman’s views come as all three major U.S. stock indexes /zigman2/quotes/210598065/realtime DJIA -0.47% /zigman2/quotes/210599714/realtime SPX -0.27% /zigman2/quotes/210598365/realtime COMP +0.14% were unable to sustain a rally during the final hour of trading on Wednesday — after having cemented a strong start to the fourth quarter with gains on Tuesday . Meanwhile, hopes for a pivot in Fed policy have faded after New Zealand’s central bank continued to raise interest rates sharply and U.S. data releases showed the economy remains solid enough for the Fed to keep hiking borrowing costs. Bond-market volatility, as measured by the MOVE Index, is at a 13-year high largely because of two important dynamics: One is that investors continue to sell Treasurys on the likelihood that persistent inflation results in continued aggressive rate hikes by the Fed. The other is that the recent selloff in bonds is pushing yields up to such attractive yields, that they’re also enticing buyers to come back in. Generally speaking, Treasury yields have soared since the start of the year toward 4% or higher, forcing investors to bring down valuations on stocks. That was the case on Wednesday, when the yield on the 1-year bill /zigman2/quotes/211347042/realtime BX:TMUBMUSD01Y +0.04% jumped 14 basis points to 3.96% and rates on 3-month through 30-year maturities all climbed. Bassman has warned that rising rates might break the correlation between stock prices and bond yields, the cornerstone of the 60/40 portfolio, as investors sell off both equities and fixed income simultaneously.As U.S. policy makers press forward with lifting the benchmark U.S. interest-rate target closer to the projected 4.6% level for next year, from a current level of between 3% and 3.25%, “the pressing question is which breaks first: the bond market, the stock market, the housing market, or the economy via rising unemployment,” Bassman wrote.In a note filled with colorful imagery, Bassman described Fed officials as being “handcuffed to ‘headline’ inflation, which cannot decline quickly enough to stave off further policy tightening.” Even if one were to assume zero inflation for the rest of the year, he says, the annual headline inflation rate from the consumer-price index is still likely to be 6.5% in December, based on projections made by using data derived from the Cleveland Fed’s Nowcast estimates. Alternatively, inflation could get to 8.6% in December after factoring in the post-COVID inflation average.

“The Fed has effectively purchased a berth on the Titanic after it hit the iceberg. Mr. Powell is conducting the band while the market is sending up rescue flares and we all wonder who will find a lifeboat,” he wrote.While he’s not predicting a 1987-style stock market crash , Bassman uses that year to illustrate his point: In October 1987, the Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA -0.47% dropped 22.6% in a single trading session, an event known as “Black Monday.” That was the year the Fed hiked the fed-funds rate target above 7% from around 6%, “with inflation barely above 4%,” Bassman said. However, it was the 10-year Treasury yield /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +0.03% advancing to around 10% in October 1987 from roughly 7% in January that year, which “ultimately broke the market.” Read also: Like slicing bread with a chain saw, the Fed still has more dirty work to do, says Wall Street veteran Meanwhile, other market indicators are pointing to trouble ahead. The spread between 2- and 10-year Treasury rates remains deeply inverted, narrowing to as little as minus 47.5 basis points on Wednesday. And the spread between 5- and 30-year swap rates is screaming “panic,” according to Bassman.

For now, he said, “stocks will not find a bottom until sometime near the end of the hiking cycle.” And while Bassman said a collapse in bank stocks or housing prices similar to the Great Financial Crisis is not in the cards, “the business of buying and selling homes is about to come to a screeching halt.”

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