Fed Minutes Cast a Shadow Over Markets

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Samantha Subin and Sarah Min of CNBC report the Dow climbs 100 points Friday, stocks post weekly losses after Fed comments:

U.S. stocks closed the week in the negative on Friday as investors braced for tighter monetary policy from the Federal Reserve.

The Dow Jones Industrial Average climbed 137.55 points, or 0.4%, to 34,721.12, while the S&P 500 dipped 0.27% to 4,488.28. The Nasdaq Composite fell 1.34% to 13,711.00, which marked its first weekly loss in four weeks.

Friday’s market moves came as investors reacted to a changing tone by the Federal Reserve, signaling it will act even more aggressively to fight inflation.

“It’s not that anything necessarily “positive” is happening or that buyers are rushing into the market, but the bad news is fully absorbed for the time being and the market is now waiting for the next data point,” wrote Adam Crisafulli of Vital Knowledge. “We’re still of the view that nothing really major occurred this week aside from the Brainard remarks Tuesday morning, and the last several days have been a function of digesting her words.”

Tech stocks led the day’s losses as investors dumped the riskier shares in anticipation of higher interest rates limiting the group’s future profit growth. Chipmakers like Nvidia and Micron, which have struggled amid supply chain shortages and concerns of a looming recession, dipped 4.5% and 1.4%, respectively, while shares of Tesla, Alphabet, and Apple inched 3%, 1.2%, and 1.4% lower

Shares of Robinhood slipped nearly 7% after Goldman Sacks downgraded the trading app to sell from neutral and UPS fell about 1% on the back of a downgrade from Bank of America citing concerns about weakening demand and declining prices in the industry.

The health-care and consumer staples sectors rallied this week as investors worried about a slowing economy pivoted toward stocks with stable earnings. Merck and UnitedHealth Group inched higher again on Friday. Both stocks closed the week 5% and 6.5% higher, respectively.

Meanwhile, financial sector companies like JPMorgan Chase and American Express rebounded, giving up some of the week’s earlier losses.

Friday’s moves come after the Fed released minutes from its March meeting on Wednesday, which revealed that policymakers plan to reduce their bond holdings by a consensus amount of about $95 billion. The central bank is also considering interest rate hikes of 50 basis points in future meetings. Ealier in the week, strong comments by Fed Governor Lael Brainard indicated the central bank could start reducing its balance sheet at a “rapid pace” as soon as May.

“Their main tool is the Fed’s funds rate, so that’s mostly it, but on top of that they’re going to start taking liquidity out of the system,” said Kathy Bostjancic, chief U.S. economist at Oxford Economics. “They’re going to reduce their purchases of treasury securities and mortgage-backed securities by a trillion per year. That’s a lot of liquidity that’s taken out of the system and private investors are going to have to fill the gap.”

The pivot by the Fed has caused rates to shoot higher, with the 10-year Treasury yield hitting a new three-year high Friday, rising above 2.7%. The rate ended last week at 2.38% and started the year at 1.63%.

“The unusually fast hiking cycle indicates that in retrospect, the Fed’s (and most economists’)‘transitory inflation’ narrative was too sanguine and the Fed now has to aggressively catch up after falling behind the curve,” wrote Maneesh Deshpande, head of U.S. equity strategy at Barclays. “We remain cautious and believe upside is limited.”

Oil prices, which have been volatile during the Russia-Ukraine war, rose slightly on Friday. U.S. West Texas Intermediate (WTI) crude added 0.5% to $96.52 per barrel, while Brent crude gained 0.5% and topped $101 per barrel. Energy companies including Occidental Petroleum and Halliburton moved higher on Friday.

Investors are also looking ahead to earnings season, which will kick off next week with reports from five big banks. JPMorgan will report before the bell on Wednesday. Citigroup, Goldman Sachs, Morgan Stanley and Wells Fargo will report before markets open on Thursday.

Alright, it's Friday, time to cover markets so let's begin with the yield on the 10-year Treasury note:

As shown above, the 10-year yield is fast approaching the October 2018 high of 3.2%.

More worrisome, the speed of "rate normalization" is nothing short of astounding. The 10-year Treasury yield went from a 52-week low of 1.13% to 2.71% in record time, with most of the backup in yields happening over the last two months:

What is causing this ferocious backup in yields? Simple. With inflation at a 40-year high and the unemployment rate at record lows, the Fed is dropping any talk about "transitory inflation" and sending a clear message to the market: "The liquidity party is over. We are going to start raising rates aggressively and cut down our purchases of Treasuries and mortgage-backed securities."

Some skeptics don't believe the Fed will go to full hawk mode, raising rates by 50 basis points at each meeting and going from QE to QT (quantitative tightening), but the truth is the Fed is way behind the inflation curve and if it doesn't act now, it risks a full-blown crisis of confidence.

How much can the Fed hike? We don't really know. Traders are pricing in an additional 225 basis points of rate hikes by the end of this year, for a total of 250 basis points, something which hasn't been done in one year since 1994:

But a lot of the tightening is already occurring in the market:

Last week, I discussed why you shouldn't ignore the inverted yield curve in an inflationary environment.

Yes, real rates remain negative but that's changing fast.

Moreover, rising mortgage rates are cooling the housing market and high inflation is impacting disposable incomes.

This too signals a major slowdown ahead.

So how far can the Fed go with rate hikes and QT? 

Well, let me share a chart with you which Senator Clement Gignac forwarded me on Wednesday:

As you can see, when household wealth is rising much faster than consumption, it means there's still too much liquidity in the system, making the Fed's job that much tougher!

Senator Gignac told me: "The Fed will continue raising rates until there's blood on the streets, meaning a 20% stock market correction (broad market not just tech stocks) or a significant widening or corporate bond yields. With the backup in yields, the S&P P/E should be at 16, not 20, so a 20% correction is more likely than not."

Now, I don't want to scare people into selling their stock holdings, but buckle up because the remainder of the year will be volatile and rough.

Like I warned you in my Outlook 2022: Beauty and the Inflation Beast: "...the speed of adjustment or 'rate normalization' matters a lot for risk assets because an abrupt increase in rates will clobber risk assets."

If you told me in early January we would be closer to 3% on the 10-year Treasury yield than 2% by mid-April, I would have been a lot more worried. 

Again, the backup in yields over the last two months is nothing short of astounding. Period.

Will it continue? It might as the Fed embarks on its tightening campaign but there's a limit to all this, at 3% or higher, the US economy will significantly slow, and so will the world economy. 

Will we see 3%, 3.5% or 4% on the 10-year Treasury yield this year? 

Who knows? Rates tend to overshoot on the upside and downside, lots of leveraged outfits betting on rates add to these swings.

All I know is there is this uneasy feeling out there and as total debt levels increase, the rise in rates will start biting everyone.

In fact, Martin Roberge of Canaccord Genuity wrote this in his weekly market wrap-up, The Line in the Sand:

Our focus this week is on US equity market valuations in a context of fast-rising bond yields. Fiscal and monetary authorities have spent several bullets to kick-start the economy during the pandemic. Therefore, we interpret the equity risk premium (ERP) as the cushion investors should demand to favour stocks over bonds considering authorities are running low on ammo to support the economy the next time down. For the record, the US and Canada look mired in a debt trap, with total consumer, corporate and government debt as a percentage of GDP at 281% and 343% respectively. In these conditions, rapid increases in bond yields tend to tighten financial conditions and curb economic growth very rapidly. This view also implies a line in the sand for the ERP owing to the positive relationship between the total debt-to-GDP ratio in the US and the ERP (see our Chart of the Week). That said, the strong rally in stocks since the March 14 low, along with the surge in bond yields, is such that the US ERP fell below 2018 lows at ~2.7% vs. ~2.4% currently. In all, this means that unless bond yields begin to decline, the S&P 500 should have difficulty breaking above the 4,600 resistance line.

So keep your eyes peeled on rates, when they rise fast, bad things tend to happen:

Alright, let me wrap it up there, it's been a long week.

Below, Frances Donald, Manulife chief economist, joins ‘The Exchange’ to explain why she believes the Fed can’t tighten as much as they would like due to sky-high inflation.

Frances is right, the Fed will have a tough time hiking nine times this year because financial conditions have already tightened considerably and PMIs are signalling a slowdown ahead.  

Still, the risks of a policy mistake are rising and the Fed's hawkish stance is alarming markets. Let's wait and see what it does at its upcoming meetings.

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