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What’s next for the stock market as the Federal Reserve moves toward the “top hawks”

Investors will watch another measure of US inflation next week after the stock market shook the Federal Reserve, which strengthened its hawkish tone and indicated that large interest rate rises were coming to bring the overheating economy under control.

“Right now, we probably see the top hawks,” James Solloway, chief market strategist and senior portfolio manager at SEI Investments Co., said in a telephone interview. “It’s no secret that the Fed is far behind the curve, with such high inflation and only one increase of 25 basis points so far.”

Fed Chairman Jerome Powell said on April 21 during a panel discussion hosted by the International Monetary Fund in Washington that the central bank was not “counting” on inflation, which peaked in March. “In my opinion, it’s a good idea to move a little faster,” Powell said, setting a 50-point rate-raising table at a Fed meeting early next month, leaving the door open for larger oversize transfers. months ahead.

US stocks closed sharply after its remarks and all three major benchmarks extended losses on Friday, with the Dow Jones Industrial Average recording the largest daily percentage decline since the end of October 2020. Investors are struggling with “very strong forces” in the market, says Steven Violin, portfolio manager at FLPutnam Investment Management Co.

“The tremendous economic momentum from the pandemic recovery is facing a very rapid shift in monetary policy,” Violin said by telephone. “Markets, like all of us, are trying to understand how this will turn out. I’m not sure anyone really knows the answer. “

The central bank wants to prepare a soft landing for the US economy in order to tighten monetary policy in order to fight the hottest inflation in about four decades without causing a recession.

The Fed “is partly to blame for the current situation, as its extremely accommodative monetary policy over the past year has left him in this very weak position,” Osterweis Capital Management portfolio managers Eddy Vataru, John Sheehan and Daniel Oh wrote in a report on their second-quarter outlook for total return fund of the company.

Osterweis portfolio managers said the Fed could raise the target rate of Fed funds to cool the economy while shrinking its balance sheet to raise rates with longer maturities and reduce inflation, but “unfortunately, implementing a dual quantitative tightening plan requires a degree of finesse. that the Fed is not known, “they wrote.

They also expressed concern about the short, recent reversal of the government bond yield curve, with short-term yields rising above longer-term yields, which they called “a rarity for this phase of the tightening cycle.” This reflects a “policy flaw” in their view, which they described as “leaving rates too low for too long and then potentially going too late and probably too much.”

Last month, for the first time since 2018, the Fed raised its key interest rate and raised it by 25 basis points from close to zero. The central bank now appears to be in a position to burden its rate increase in advance with a potentially larger increase.

“There’s something to the front-end loading idea,” Powell said during a panel discussion on April 21. James Bullard, President of the Federal Reserve Bank of St. Louis said on April 18 that he did not rule out a large increase of 75 basis points, although that was not his basic case, the Wall Street Journal reported.

Read: Futures Fed traders see 94% probability of Fed increase by 75 basis points in June, CME data show

“It is very likely that the Fed will move 50 basis points in May,” but the stock market has a ‘harder time to spend’ idea that a half-point increase could also come in June and July, Anthony said. Saglimbene, global market strategist at Ameriprise Financial, in a telephone interview.

Dow DJIA, -2.82% and S&P 500 SPX, -2.77%, fell nearly 3.0% on Friday, while Nasdaq Composite COMP, -2.55% fell 2.5%, according to Dow Jones Market Data. All three major benchmarks ended the week with losses. The Dow fell for the fourth week in a row, while the S&P 500 and Nasdaq fell for the third week in a row.

The market is “resetting to the idea that we will move to a more regular Fed fund rate much faster than we probably thought” a month ago, according to Saglimbene.

“If it’s the top hawks and they’re pushing really hard to offset,” Violin said, “maybe they’ll buy more flexibility later in the year when they start to see the impact of a very quick return to neutral.”

A faster rate of interest rate increases by the Fed could bring federal funds rates to a “neutral” target of around 2.25% to 2.5% by the end of 2022, potentially earlier than investors estimated, according to Saglimbene. According to him, the rate, which now ranges from 0.25% to 0.5%, is considered “neutral” if it neither stimulates nor restricts economic activity.

Meanwhile, investors fear that the Fed, according to Violin, will reduce its balance sheet by about $ 9 trillion as part of its quantitative tightening program. The central bank is aiming for a faster pace of decline compared to its recent quantitative tightening effort, which swept the markets in 2018. The stock market collapsed that year around Christmas.

“The current anxiety is that we are heading to the same point,” Violin said. When it comes to reducing the balance sheet, “how much is too much?”

Saglimbene said he expects investors to largely “overlook” quantitative tightening until the Fed’s monetary policy becomes restrictive and economic growth “slows” significantly.

The last time the Fed tried to develop its balance sheet, inflation was not an issue, said Solloway of SEI. Now they are “staring” at high inflation and “know they need to tighten things up.”

Read: US inflation jumps to 8.5%, CPI shows as higher gas prices hit consumers

At this stage, the Hawk Fed is “deserved and necessary” to fight the rising cost of living in the United States, Luke Tilley, chief economist at the Wilmington Trust, said in a telephone interview. But Tilley said he expects inflation to ease in the second half of the year and the Fed will have to slow down rates “after it does this preload.”

According to Lauren Goodwin, an economist and portfolio strategist at New York Life Investments, the market may have “come to terms with expectations of a tightening of the Fed this year.” The combination of the Fed’s tourism program and the quantitative tightening program “could tighten financial market conditions” before the central bank is able to raise interest rates by as much as the market expects in 2022, she said over the phone.

Next week, investors will closely monitor March inflation data measured by the personal consumption and expenditure price index. Solloway expects PCE inflation data to be released by the US government on April 29 will show rising living costs, in part because “energy and food prices are rising sharply.”

Next week’s economic calendar also includes data on U.S. home prices, new home sales, consumer sentiment, and consumer spending.

Ameriprise’s Saglimbene said he would follow quarterly corporate earnings reports from consumer-focused technology companies and megacap next week. “They will be extremely important,” he said, referring to Apple Inc. AAPL, -2.78%, Meta Platforms Inc. FB, -2.11%, PepsiCo Inc. PEP, -1.54%, Coca-Cola Co. KO, -1.45%, Microsoft Corp. MSFT, -2.41%, General Motors Co. GM, -2.14% and parent company Google Alphabet Inc. GOOGL, -4.15% as examples.

Read: Investors have just withdrawn a massive $ 17.5 billion from global stocks. They’re just starting, says Bank of America.

Meanwhile, FLPutnam’s Violin said it was “quite comfortable when it remains fully invested in the stock markets.” He said there was a low risk of recession, but said he preferred “here and now” cash flow companies to more growth-oriented businesses with expected profits far into the future. Violin also said he likes companies ready to benefit from higher commodity prices.

“We have entered a more unstable time,” warned Solloway of SEI. “We really need to be a little more cautious about how much risk we should take.”