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Wall St Week Ahead: Last Fed hike tends to aid stocks, but some have doubts this time

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Wall St Week Ahead: Last Fed hike tends to aid stocks, but some have doubts this time
© Reuters. Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., August 15, 2023. REUTERS/Brendan McDermid/File Photo

By Lewis Krauskopf

NEW YORK (Reuters) – The end of the Federal Reserve’s rate hiking cycle has generally been a good time to own U.S. stocks, but an uncertain economic outlook and stretched valuations could dampen upside this time around.

After raising borrowing costs by 525 basis points since March 2022, the U.S. central bank is widely expected to keep rates unchanged at the conclusion of its meeting next week. Many investors believe that policymakers are unlikely to raise rates any further, bringing an end to the central bank’s most aggressive monetary policy tightening cycle in decades.

If they are right, stocks could be poised for more gains. After the Fed’s past six periods of credit tightening, the rose an average of 13% from the final rate hike to the first cut in the following cycle, an analysis by financial research firm CFRA showed.

Investors with a more bearish view, however, say it is only a matter of time before higher rates tighten economic conditions and bring a downturn. The S&P 500 is already up over 16% this year, aided in part by a U.S. economy that has stayed resilient in the face of higher interest rates.

“The market will probably cheer it a bit if it is the end of the Fed rate hike cycle,” said Schutte, chief investment officer at Northwestern (NASDAQ:) Mutual Wealth Management Company.

However, “I don’t think the economy is going to stay out of a recession and that is going to be what ultimately decides the direction of stocks,” said Schutte, whose firm favors fixed income over equities.

Though most investors believe a recession is unlikely in 2023, a slowdown next year remains a possibility for some market participants. One worrying recession signal has been the inverted Treasury yield curve, a market phenomenon that has preceded past downturns.

The Fed will give its policy statement on Wednesday, with odds at 97% that it will keep rates unchanged, according to the CME FedWatch Tool, which tracks bets on futures tied to the central bank’s policy rate. Traders see a roughly two-out-of three chance of the Fed leaving rates unchanged in November, CME’s data showed.

Odds for December show about a 60% chance rates of rates staying at current levels.

PEAK RATES?

Fed Chair Jerome Powell said last month that the central bank may need to raise rates further to cool inflation, promising to move carefully at upcoming meetings.

More of the kind of generally benign inflation data that has come over the last few months, however, could mean the Fed’s quarter-point increase in July was the last in a cycle that shook asset prices last year.

“If Wall Street comes to the conclusion that the Fed has ended its rate tightening program, that would at least offer support if not give (stocks) an additional catalyst to keep working higher,” said Sam Stovall, CFRA’s chief investment strategist.

Investors are also attempting to gauge when the Fed will begin easing monetary policy. CFRA found that the Fed has tended to cut rates an average of nine months after its last rate increase, with the S&P 500 gaining an average of 6.5% in the six months following the cut.

Investors are pricing in a small chance of a cut as early as the Fed’s January meeting, with expectations of a cut at about 35% for May, according to the CME data.

Some investors, however, see challenges for the stock market even if the Fed is done hiking.

Analysts at Oxford Economics forecast further downside for global earnings, noting that stocks “have typically delivered far weaker returns following the final Fed rate hike when it has coincided with an EPS downturn.”

Oxford and other investors are also wary of stock valuations, which have ballooned this year. The S&P 500 is trading at about 19 times forward 12-month earnings estimates versus 17 times at the start of the year and its long-term average of 15.6 times, according to LSEG Datastream.

Equity valuations are also threatened by the rise in bond yields, which has increased the attraction of fixed income as investment alternative to stocks. The yield on the 10-year Treasury is close to over 15-year highs. “If (the Fed) came out and said ‘we’re done,’ yeah I do think that is probably cause for some celebration,” said Jack Ablin, chief investment officer at Cresset Capital. “But I’m not sure how sustainable it would be given where stocks are valued relative to bonds already.”

Economy

Federal Reserve Officials Hint at Prolonged Borrowing Costs to Control Inflation

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Federal Reserve Officials Hint at Prolonged Borrowing Costs to Control Inflation

In recent developments, two officials from the Federal Reserve hinted on Friday at the possibility of an additional increase in interest rates. The move is seen as a necessary measure to bring inflation under control and return it to the central bank’s target of 2% in the United States.

These officials also suggested that higher borrowing costs might need to be maintained over an extended period to accomplish this objective. This indicates a potential shift in the monetary policy landscape, with a prolonged period of elevated borrowing costs looming on the horizon.

The decision to increase interest rates is often used by central banks as a tool to manage inflation. By making borrowing more expensive, it reduces the amount of money circulating in the economy, thereby controlling price levels. The Federal Reserve’s current target for inflation is 2%, a figure that it strives to achieve for economic stability.

This latest indication from Federal Reserve officials underscores the ongoing challenges faced by the central bank in managing inflationary pressures in the United States. It also highlights their commitment to deploying necessary measures, including potential interest rate hikes and sustained higher borrowing costs, to achieve their stated inflation targets.

This article was generated with the support of AI and reviewed by an editor. For more information see our T&C.

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Economy

Column-Hawkish Fed unwittingly stokes Treasuries ‘basis trade’ risks: McGeever

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Column-Hawkish Fed unwittingly stokes Treasuries 'basis trade' risks: McGeever

By Jamie McGeever

ORLANDO, Florida (Reuters) – The Federal Reserve’s hawkish stance on interest rates, and determination to reduce its balance sheet, may inadvertently be stoking financial stability risks by encouraging hedge funds to extend or even increase their “basis trade” bets in the U.S. bond market.

The trade – a leveraged arbitrage play profiting from the price difference between cash bonds and futures – has exploded since the Fed began tightening policy last year, to such a degree that central banks and regulators are now closely monitoring.

The Bank for International Settlements warned this month that the huge build-up in speculators’ short Treasuries position “is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger.”

A Fed paper on Aug. 30 noted that if these positions represent the so-called basis trades, “sustained large exposures by hedge funds present a financial stability vulnerability” warranting “continued and diligent monitoring.”

The trade is often more profitable in an environment of rising and elevated interest rates. The higher rates stay, the longer funds hold the position and the longer a potentially disruptive unwind is put off.

Crucially, though, it also needs stable funding conditions, ample liquidity and relatively low or steady volatility. A “higher-for-longer” steady Fed might tame inflation, but at some point increases the risk of financial shocks.

Policymakers hope tighter money gradually lets the air out of this and other balloons rather than bursting them. Sudden and large reversals in prices or policy rates are undesirable. It is a delicate balance.

As long as rates and yields are manageable, overall liquidity is ample, and funding conditions in the Treasury repurchase market remain favorable, there is every incentive for funds to hold the position.

These stars are still in alignment.

“As QT (quantitative tightening) continues and more liquidity gets drained out of the system, repo rates will move higher, funding will get tighter, and conditions for long-basis positions will become less favorable,” says Steven Zeng, a strategist at Deutsche Bank.

“But we’re not there yet. We’ll perhaps start to see funding pressure develop around the middle of next year,” he reckons.

NICKELS & STEAMROLLER

Estimating the size of hedge funds’ basis trade bets is difficult because transparency and visibility around hedge funds is so low at the best of times, especially with regard to their more complex activities and strategies.

Many analysts look at leveraged funds’ position in Treasuries futures, and the Aug. 30 Fed paper also noted speculators’ repo borrowings.

Hedge funds’ repo borrowing via the Fixed Income Clearing Corporation’s centrally-cleared bilateral repo market more than doubled to a historically high $233 billion between October 2022 and May of this year. This is a fairly reliable sign of basis trade activity, the Aug. 30 Fed paper says.

Overnight repo rates have steadily tracked the fed funds policy rate since March 2022. There has been none of the volatility and price spikes of 2019 or early 2020.

Commodity Futures Trading Commission figures, meanwhile, show that leveraged funds have amassed a huge net short position in two-, five- and 10-year Treasuries futures worth around $700 billion, a position matched by asset managers on the other side.

Worryingly for regulators, funds’ short positions are approaching the previous record in 2019. They are already bigger than early March 2020 when the coronavirus pandemic shut down the economy, a wave of volatility crashed over the U.S. bond market, and the Fed slashed rates to the near-zero level and launched unlimited, open-ended large-scale asset purchases.

Basis trade liquidation, as funds got squeezed out of their positions through margin and collateral calls as volatility rocketed, likely contributed to that dislocation.

It’s impossible to quantify the impact this unwind had, but the ‘s volatility at the time is worth noting: it fell 100 basis points between Feb. 20 and March 9, rebounded 75 basis points over the next nine days, then slumped 65 basis points by the end of the month.

Avoiding a repeat and ensuring as smooth an unwind as possible this time around, whenever it comes, will be crucial to the functioning of the world’s most important financial market.

Christoph Schon, senior principal for applied research at Axioma, says that if the Fed keeps rates around their current level for the next nine months, as rates markets currently indicate, the basis trade balloon will continue to expand.

Asset managers will see strong client demand from investors looking to lock in the highest yields since before the global financial crisis, and hedge funds will “scramble to pick up the nickels in front of the basis trade steamroller.”

(The opinions expressed here are those of the author, a columnist for Reuters)

(By Jamie McGeever; Editing by Paul Simao)

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Economy

ECB Holds Rates at 4% Amid Economic Stability, Aims to Curb Inflation

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ECB Holds Rates at 4% Amid Economic Stability, Aims to Curb Inflation

The European Central Bank (ECB) has decided to hold its interest rates at 4% for the foreseeable future, following a hike of 0.25 percentage points last week. This decision comes as the bank seeks to reduce inflation to its target of 2%, according to the ECB’s Chief Economist, Philip Lane.

Lane expressed confidence in the rate increment’s ability to significantly curb inflation, despite acknowledging considerable uncertainty surrounding this decision. He underscored the need to maintain the 4% rate for a substantial period to effectively manage inflation and affirmed that the bank’s decisions will continue to be data-driven.

In a discussion with Jennifer Schonberger last week, Lane provided an assessment of the current economic climate, describing it as stable rather than fragile. He attributed this stability to the robust health of the banking system and improved household and corporate balance sheets in the aftermath of the pandemic.

Addressing concerns about a potential deep recession, Lane stated that the necessary conditions for such an event are currently absent. His insights were part of a broader discussion available on a financial news platform.

This article was generated with the support of AI and reviewed by an editor. For more information see our T&C.

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