As the Fed sets the stage for March rate hike, stock investors face a ‘perilous’ backdrop of heightened volatility

Investors, especially those dependent on computer-generated buy or sell decisions, face a dangerous backdrop of Federal Reserve-led volatility after a brutal month of stock trading.

The violent movements in stocks in January offer a glimpse of what could still be in store: the S&P 500 SPX,
and Nasdaq Composite COMP,
indices ended the month with their biggest percentage declines since March 2020, while the Dow Jones Industrial Average DJIA,
staged an unprecedented 1,214 point knockdown in a single day last week. Meanwhile, two- and five-year Treasuries, whose rates reflect the short-to-medium term trajectory of Fed policy, are off to their worst start to the year in more than three decades, according to Dow Jones Markets. Data.

The problem is uncertainty over how far the central bank is willing to go to tackle the highest US inflation in nearly 40 years, starting with a widely expected rate hike in March, investors say. and strategists. Ironically, this uncertainty gives way to at least one area of ​​clarity: large market swings are likely here to stay.

“Volatility is probably the only thing my compliance department would allow me to guarantee,” said John Lynch, Charlotte, North Carolina-based chief investment officer for Comerica Wealth Management, which oversees $175 billion in assets. . “It could take 15 to 18 months until we get full clarity on the extent of Fed tightening, and the market is likely to see more episodes before then.”

Meanwhile, “investors should be prepared for greater stock market volatility, and those caught up in quantitative or algorithmic trading may be hurt,” he said by phone Tuesday.

Two competing forces complicate the Fed’s task ahead: The first is the likelihood of no slowing in inflation in the near term, given signs of mounting price pressures from factors unrelated to supply shortages. labor and supply in the United States. They include strong demand for commodities and drought conditions outside the United States that drive up the price of commodities like soybeans.

The other force is concern about a potential economic slowdown – as reported by International Monetary Fund in January, and the Treasury market, which has issued repeated warnings about growth prospects since October. While many say higher inflation argues for more aggressive rate hikes from the Fed, the prospect of a slowdown supports the idea that inflation could come down and policymakers need to be more cautious. about tightening – which together generate even more volatility for Financial Markets.

The Fed will “struggle” to raise the fed funds rate target to its long-term target of 2.5%, from a current level between 0% and 0.25%, and is more likely not to exceed 1.5% for 2%, according to Comerica’s Lynch. Despite growing expectations that the Fed could offer a half-point hike in March, a lower-than-expected nonfarm payrolls report for February could be enough to remove that option, he said.

Add to this environment an ongoing debate about the extent to which the Fed’s nearly $9 trillion balance sheet reduction will tighten financial conditions or could replace rate hikes – a process some have called a “double tightening.” .

Read: What to expect from the markets over the next six weeks, before the Federal Reserve revamps its easy money policy

In a note from BofA Global Research on Monday, strategists Andy Pham and Francisco Blanch, along with analyst Chintan Kotecha, wrote that “with asymmetrically higher risks virtually confirmed by the Fed after the January meeting, we believe that quantitative investors should brace themselves for a rising theft environment.

They said they see the backdrop as “perilous”, but say “pockets of alpha can still be found in commodity and currency risk premia”.

Quantitative systems have been used in recent years as a way to beat the market and post strong returns, while high frequency trading algorithms have helped make trading cheaper for many and account for a large part of the market. buying and selling of US stocks that take place.

Benchmarks for U.S. stocks shook off a tentative start on Tuesday night, with the Dow Jones industrials, S&P 500 and Nasdaq Composite all posting gains. Meanwhile, Treasury yields were also higher, with the 10-TMUBMUSD10Y,
and 30-year rate TMUBMUSD30Y,
having their biggest advances in almost a week.

“We’re going to see increased volatility across asset classes, and it’s very possible that quantitative investors will be the hardest hit,” said Calvin Norris, portfolio manager and US rates strategist at Aegon Asset Management in Cedar Rapids. , Iowa, which oversees $463.8 billion. . “I agree that it will be a long time before we ease many of the factors driving inflation, and there is reason to believe that we will see an inflation tailwind. for a certain time.”

“The pace of Fed rate hikes and the pace of balance sheet liquidation, we don’t know. So at this point the market is left to its own imagination and can tell a hawkish or dovish story to itself,” he said. he said over the phone.

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