Warnings abound in market circles as fed error bets seen rising

Investors should adopt a softly softly approach in assessing trading opportunities after a hawkish Federal Reserve raised interest rates.
Image: Bloomberg

Investors should adopt a softly softly approach in assessing trading opportunities after a hawkish Federal Reserve raised interest rates and signaled more to come.

That’s the view of market participants who caution against making mega bets after the central bank flagged hikes at all six remaining meetings this year to tackle the fastest inflation in four decades.

“If they do follow through on what the dot plot suggests that’s worrisome. The risk of a policy mistake went up materially today,” said Ron Temple, co-head of multi-asset at Lazard Asset Management in New York. “Markets are going to need time to assess what a multi-dimensional tightening feels like.”

Bond markets are already flashing their concern: the spread between five- and 30-year Treasuries has narrowed to its flattest since 2018. With the curve a gauge of the market’s sense of the economy, the flattening is in part down to bets on Fed policy error weighing on the recovery — something which increases in likelihood with faster, higher rate hikes.

Still, US stocks closed higher after positive comments on the economy from Fed Chair Jerome Powell, China’s more market-friendly policy stance and possible progress on cease-fire talks between Russia and Ukraine.

Here are selected comments on what’s next for global markets following the Fed:

No equity bottom yet

“We are continuing to advise caution: there are some great companies, with strong moats around their business, which are on sale and we have been taking advantage of the selloff, but we are not ready to declare the bottom is in and that it’s time to get more aggressive across the board,” said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance. “We are in unprecedented territory in terms of the size of the Fed’s balance sheet, the inflationary pressures on the US economy and the increasing threats to economic growth; and a humble approach to investing, with less conviction in any one particular outcome, is warranted.”

Cause for concern

The equity market rally is surprising, and “this is not cause for optimism, this is cause for concern,” said Lazard’s Temple. He sees three tightening measures simultaneously: higher interest rates, balance sheet run-off and higher oil prices as a tax on U.S. consumers.

Interest rate volatility

“It seems to me that the Fed is leaving it to financial markets to dictate the path of the fed funds rate,” said Bill Zox, portfolio manager at Brandywine Global Investment Management. “That approach will lead to more interest rate volatility than if the Fed were engaged in more of a two-way interaction with the financial markets. If investment-grade bonds, high-yield bonds and stocks do continue to decline, we may find out when the Federal Reserve is willing to get more involved in a two-way interaction with the financial markets.”

Buy commodity currencies

“History tells us that the USD tends to lose altitude once the Fed begins its tightening cycle,” said Rodrigo Catril, strategist at National Australia Bank Ltd. “Overall there are plenty of uncertainties, but we still think commodity-linked currencies are well placed to perform this year while the euro could regain its mojo with gusto in the second half of 2022, if we get an ECB preparing to hike alongside an EU expenditure plan to wean itself from Russia.”

Front-loading hikes

“We are less convinced on the underlying strength in both demand and labor markets, so remain skeptical that they follow through with their full hiking program,” Steven Englander, head of G-10 foreign exchange research at Standard Chartered Plc., wrote in a note. “The Fed may use the next few meetings to front-load hikes while such moves are popular politically and with the public.”

Buy treasuries

“The attractiveness is high for Treasury intermediate and long notes,” said Makoto Noji, chief currency and foreign bond strategist at SMBC Nikko Securities Inc. “The US yield curve has almost fully priced in the dots plot, meaning bond investors expect US economy to remain resilient to the extent that the Fed can complete all the rate hikes planned.”

Euro bid

“The hawkish Fed does open the door to a more hawkish ECB iteration and as we have seen in past episodes where the markets price out negative interest-rate policy, the euro flies,” said Stephen Innes, managing partner at SPI Asset Management. “And since ceasefire trades have become increasingly popular, particularly in the energy market, I think EUR/USD could hold a bid. Lower energy prices are good for the EU economy hence the euro.”

Higher rates

“There appears to be some commitment to quantitative tightening from the Fed, but there still is some uncertainty around what that translates into for investors,” said Charlie Ripley, senior market strategist for Allianz Investment Management. “Overall, the message is clear from the Fed that policy rates will be much higher by the end of the year. Now it is up to the market to become more comfortable with the hawkish stance.”

“We are looking for the 10y to reach 2.5% by year-end and 2.75% by mid-year 2023. In addition, fixed income funds continue to witness outflows, which should also pressure rates higher,” wrote TD Securities strategists including Oscar Munoz and Priya Misra. “A restrictive terminal rate and QT should move long end real rates higher. We remain short 10y real rates.”

Emerging market caution

“EM central banks will need to tighten more, to keep up pace with the Fed and to tackle their domestic inflation,” said Rajeev De Mello, global macro portfolio manager at GAMA Asset Management. “I‘m most worried about countries which have been reluctant to tighten so far, those which are most dependent on energy. India is particularly exposed on these two fronts. Yields in many local markets have reached attractive levels and will present investment opportunities when commodity prices settle down.”

© 2022 Bloomberg

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