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What to expect from markets in the next six weeks, before the Federal Reserve revamps its easy-money stance

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 groundwork 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 VIX, -9.28%, 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 do not 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 COMP, + 3.13% 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 RUT, + 1.93% 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 US investment-grade corporate bonds LQD, + 0.11%, their high-yield HYG, + 0.28% counterparts and fixed-income AGG, + 0.07% generally to begin the year, but also the deeper rout in growth and value stocks, and losses in international EEM, + 0.49% 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 annual 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 did not 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 at 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

"It's a bidding war for who can predict the most rate hikes," Kathy Jones, chief fixed income strategist at Schwab Center for Financial Research, told MarketWatch. "I think we are reaching peak panic about Fed rate hikes."

"We have three rate hikes penciled in, then it depends on how quickly they decide to use the balance sheet to tighten," Jones said. The Schwab team pegged July as a starting point for a roughly $ 500 billion annually draw down of the Fed's holdings in 2022, with a $ 1 trillion reduction an outside possibility.

"There's a lot of short-term paper on the Fed's balance sheet, so they could roll off a lot really quickly, if they wanted to," Jones said.

Time to play safe?

“You have the largest provider of liquidity to markets letting up on the gas, and quickly moving to tapping the brakes. Why increase risk right now? ”

- Dominic Nolan, chief executive officer at Pacific Asset Management

It's easy to see why some beaten down assets might finally end up on shopping lists. Although, tighter policy has not even fully kicked in, some sectors that ascended to dizzying heights helped by extreme Fed support during the pandemic have not been holding up well.

"It has to run its course," Jones said, noting that it often takes "ringing out the last pockets" of froth before markets find the bottom.

Cryptocurrencies BTCUSD, -0.35% have been a notable casualty in January, along with giddiness around “blank-check,” or special-purpose acquisition corporations (SPACs), with at least three planned IPOs shelved this week.

"You have the largest provider of liquidity to markets letting up on the gas, and quickly moving to tapping the brakes," said Dominic Nolan, chief executive officer at Pacific Asset Management. "Why increase risk right now?"

Once the Fed is able to provide investors will a more clear road map of tightening, markets should be able to digest constructively relative to today, he said, adding that the 10-year Treasury yield TMUBMUSD10Y, 1.771% remains an important indicator. “If the curve flattens substantially as the Fed raises rates, it could push the Fed to be more aggressive [tightening] in an effort to bridge the curve. ”

Climbing Treasury yields have pushed rates in the US investment-grade corporate bond market near 3%, and the energy-heavy high-yield component closer to 5%.

"High yield at 5%, to me, that's better for the world than 4%," Nolan said, adding that corporate earnings still look strong, even if peak levels in the pandemic have passed, and if economic growth moderates from 40-year highs.

Draho at UBS, like others interviewed for this story, views the risk of a recession in the next 12 months as low. He added that while inflation is at 1980s highs, consumer debt levels also are near 40-year lows. "The consumer is in strong shape, and can handle higher interest rates."

US economic data to watch Monday is the Chicago PMI, which caps the wild month. February kicks off with the Labor Department's job openings and quits on Tuesday. Then its ADP private sector employment report and homeownership rate Wednesday, following by the big one Friday: the January jobs report.

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