Why stock market investors fear a full percentage point Fed rate hike could “unnerve” Wall Street

With US equities and bonds under pressure on Tuesday, some on Wall Street argue that investors are underestimating the possibility that the Fed could make a surprise 100bp hike in interest rates at the end of Wednesday’s two-day policy meeting. .

While fed-funds futures traders are overwhelmingly predicting a 75 basis point increase, or 0.75 percentage point, on Wednesday, their concern is that last week’s August consumer price index print combined to the still solid job market, may have convinced Fed Chairman Jerome Powell (and other hawks on the Fed’s policy-making committee) that they need to do more than just stay on course as they struggle to curb inflation.

Instead, Fed policymakers may feel they need to act more forcefully.

If that happens, it would mark the most aggressive example of Fed tightening since the days of former Fed Chairman Paul Volcker, in the wake of three “jumbo” rate hikes of 75 basis points.

See: Biggest Fed rate hike in 40 years? It could come this week.

Many are concerned that lowering the hammer so forcefully would risk unleashing pandemonium in the markets, essentially eliminating the likelihood of a “soft landing” for the US economy. Others are more concerned that failing to get markets up to speed now could risk much worse consequences down the road.

How would the markets react?

Sam Stovall, CFRA’s chief investment strategist, said in a note to clients that a 100 basis point hike would represent an “overreaction” from the Fed.

“We think a 100 bps hike would unnerves Wall Street, as it would imply that the FOMC is overreacting to the data rather than sticking to its game plan and increase the likelihood that the FOMC will eventually over-tighten and reduce the chance of getting a soft landing, ”Stovall wrote in a note to customers.

With short-term yields already approaching the pressure point of around 4%, the always carefully choreographed Fed may not want to risk disrupting the markets in such a lighthearted way.

See: A punitive short-term debt sell-off is pushing a rate close to the “magic” level that “scares” the markets

“The Fed telegraphed 75 basis points. If they were to hit 100 basis points, I think it would be shocking to the market, “said David Rubenstein, the founding billionaire of the private equity giant Carlyle Group, during an interview with Fox Business on Monday.

But assuming the Fed opts for a surprise percentage point hike, some can imagine a scenario in which markets will rally in the face of a more strident Fed.

“Not foreseeing this in any way, but I could see a scenario where we get 100 and the market actually recovers (after the initial color) based on the idea that the Fed is tearing the patch instead of slowly removing it,” he said. said Matt Tuttle, CEO of Tuttle Capital Management, in an email exchange with MarketWatch.

What’s the point?

To be sure, a 100 basis point increase is still widely seen as a low probability outcome. Fed funds futures markets are currently pricing in about an 80% probability of a 75bp hike on Wednesday, with the odds of a full one percentage point move lingering at 20%, according to the CME’s FedWatch tool. .

So far, Japanese investment bank Nomura was one of the few large sell-side institutions to ask for a 100 basis point hike on Wednesday.

But the argument that the Fed might decide to deviate from its policy of carefully choreographed moves has clearly resonated with investors, highlighted by the fact that so many Wall Street strategists have chosen to address the possibility in the research they provide to clients and clients. average .

In a research note published early Tuesday, Nomura cross-asset strategist Charlie McElligott explained why he believes markets are “significantly underestimating” the prospect of a 100 basis point hike.

His reasoning: Following the latest batch of economic data, Powell simply cannot risk a positive market reaction on Wednesday, as this would lead to a “counterproductive” easing in financial conditions, which occurs when stock prices rise and bond yields. decrease.

If Powell’s goal is to prevent inflation from becoming entrenched, he must demonstrate that he is “fully involved in his unique hawkish ‘inflation’ mandate,” especially as economic data suggests that an incipient wage-price spiral is already. taking root, McElligott wrote.

“100bps is a necessity to be at the forefront of hitting the demand side of inflation as hard as possible,” McElligott said in a note to clients Tuesday.

See: Can the Fed tame inflation without further squeezing the stock market? What investors need to know.

What is the alternative?

If the Fed were to make a 100bp hike, such an aggressive move would force markets to contend with the possibility that the fed-funds rate could exceed 5% next year, which would be anathema to investors. markets and perhaps for the economy. This is why JPMorgan Chase & Co. economist Michael Feroli avoided making his base case by 100 basis points.

See: A rising dollar is already sending “warning signs,” economists warn

“We think the odds of a 100 basis point move, although certainly not zero, are less than a third … good drivers do not increase their speed as they approach their destination,” Feroli wrote in a note to customers posted on the middle of last week.

Instead, as Feroli informed JPM clients last week, the US mega-bank expects the Fed to post a slightly larger increase in November, along with a further 25 basis point hike early next year. The additional 50 basis points of the expected tightening would help bring the Fed’s top interest rate target range by next spring to 4.25%, which is still much higher than many expected in July.

Anything beyond that will depend entirely on the state of the economic data.

“If the labor market is not cooling down materially by January-February, then we will seek the Committee to continue to tighten with movements of 25 basis points until this occurs,” added Feroli.

US stocks traded lower on Tuesday, with the S&P 500 SPX,
-1.07%
by more than 1% and the Dow Jones Industrial Average DJIA,
-1.02%
down by nearly 400 points around noon. The Nasdaq Composite COMP,
-0.82%
it was also firmly in red. Meanwhile, the 2-year Treasury yield TMUBMUSD02Y,
3.970%
it was trading at just under 4%, seen as a level that could create more headaches for the stock market.

See: Because rising Treasury yields are holding back the stock market

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