The FED talk
Higher interest rates may eventually be negative for stocks and cause bond market selling.
The Fed signaled in its statement and projections on Wednesday, capping off its two-day meeting, that it is moving toward announcing a reduction in its bond purchases this year. If progress continues as expected, the Fed says a “moderation in the pace of asset purchases may soon be warranted.”
According to the Fed’s forecasts, members expect higher inflation, and half of the 18 Fed officials may consider raising interest rates next year.
‘A little hawkish’
In June, the vast majority of Fed officials predicted no rate hikes in 2022 and two hikes in 2023. Its latest forecast still does not include a full rate hike, but nine members said they expect one or more rate hikes next year. Currently, the central bank’s fed funds target rate is set at zero to 0.25 percent.
“In the end, it was a little hawkish,” said John Briggs of NatWest Markets. “Powell’s tone indicated that he was ready to go, and he basically stated that the fact that they want to end tapering by mid-2022 is more important than when they start because it tells you when they start the clock on rate hikes.”
Stocks, which had been rising all day, continued to rise Wednesday afternoon following the Fed announcements and a press conference by Fed Chairman Jerome Powell. The Dow Jones Industrial Average closed off its highs but was still up 338.48 points, or 1%. On Thursday, futures rose once more.
The market isn’t even paying attention to the new rate hike forecast, he said. “First and foremost, we must complete the tapering process….” We have another five or six weeks before we have to make a decision. If history is any guide, I don’t think it will be easy to avoid rate hikes.”
Since the financial crisis, every move the Fed has made to tighten has resulted in a negative stock market reaction, according to Boockvar. “They just got a six-week pass,” he said, adding that the market frequently reacts to Fed changes after the first day.
A bond ‘flattening trade’
Following the Fed’s announcement, the yield on the 2-year Treasury note increased to around 0.23 percent. The central bank’s interest rate moves have the greatest impact on the 2-year.
“With Powell saying that the committee believes tapering will end in the middle of next year, that opens the door to a rate hike at the end of next year,” Briggs said. “It’s a flattening trade, which is a traditional rate hike cycle trade. It’s not huge, but it’s well-established in the market.”
This trade was reflected in a larger move higher in the short end of the Treasury yield curve, or the 2-year note, compared to a slight increase in the 10-year note yield. The trade is known as “flattening” because it brings both yields closer together. Interest rate hikes cause the curve to flatten because it is assumed that economic growth will be lower during the rate-hiking cycle.
The Fed did not specify a timetable for beginning the taper, giving itself wiggle room in the event that the debt ceiling fight in Congress turns negative or the pandemic worsens. However, market experts believe that the Fed will announce at its November meeting that it plans to reduce its $120 billion in monthly bond purchases, which could begin in December.
“Beginning tapering is akin to jumping off a high diving board. The time to ponder whether there is enough water in the pool is not on the way down, and they basically said let’s postpone a meeting,” said Vince Reinhart, Mellon’s chief economist. “I believe everyone will shift their focus to the announcement at the next meeting, which will kick off the following month. It meets the previous guidance of beginning tapering by the end of 2021.”
The focus will now shift to the September employment report, according to Reinhart, but Powell believes enough progress has been made on the labor front. “In my opinion, the test for significant further progress on employment has been met,” Powell said.
According to Diane Swonk, chief economist at Grant Thornton, the Fed is clearly concerned about inflation, even though it is still referred to as “transitory.” This is evident in the growing number of members expecting a rate hike next year. The employment report is important, but it may be meaningless if it is weaker than expected once more. Only 235,000 new jobs were added in August.
“Powell stated that even if the next one is softer, it will not prevent them from tapering. This is more hawkish on interest rates over the next two years. Swonk stated, “It’s not insignificant.”
The Fed now expects core inflation to rise to 3.7 percent this year, up from 3 percent in June. Inflation is expected to be 2.3 percent next year, up from 2.1 percent in the previous forecast. Headline inflation, which includes food and fuel, is expected to reach 4.2 percent this year, up from 3.4 percent in June.
Higher inflation is reflected in the Fed’s new interest rate forecasts. “That is significantly faster than what we had coming out of the financial crisis. Their worries about inflation are clearly growing,” Swonk added.
She, too, stated that the stock market appeared to be oblivious to the headlines.
“I believe they are complacent. This is a financial market that is consistently complacent. They have faith in the Fed,” she said, adding that if inflation becomes too high, the Fed will have to combat it with interest rate hikes, which will be negative for markets.
Following its September meeting, the Fed stated that tapering its Covid-era asset purchases, which increased the money supply and stimulated the economy during the pandemic, “may soon be warranted.”
Fed Chair Jerome Powell stated in a press conference following the meeting that the central bank expects the bond-buying program to end around the middle of 2022.
Analysts examined the five most recent major increases in the 10-year Treasury yield in the United States. These five periods lasted from 2013 to March 2021, with the most recent phase ending in March 2021.
During these rising-rate intervals, we identified the stocks that increased each time, with an average gain of at least 30%.
From there, we culled the names that were popular on Wall Street.
Except for one name, all of the names have outperformed the Dow Jones this year, which has gained 15.9 percent in 2021 as of Monday’s close.
The majority of the stocks on the list are in the financial sector. Higher interest rates imply that banks charge higher interest rates on loans, which typically boosts profits.
Typically, Charles Schwab stock is a big interest rate play. Schwab pays a low interest rate to customers who have cash in their accounts, and then uses that cash to buy higher yielding instruments, such as mortgage-backed securities, and to make loans with the funds from those deposits. During rising-rate periods, the company gains 45.6 percent on average.
Banks such as Bank of America, Goldman Sachs, and JPMorgan are also depicted on the screen. Approximately 55% of analysts covering those stocks advise investors to buy them. Analysts believe Bank of America and Goldman Sachs’ shares can rise 13.1 percent from current levels, while JPMorgan has a 10.1 percent implied upside.
There are a few cyclical names on the list as well. Cyclical stocks are those that are typically linked to the economic cycle. During rising-rate periods, Caesars Entertainment and Deere & Co have average gains of 58.1 percent and 31.6 percent, respectively.
On Wednesday, the firm’s derivatives research team compiled a list of funds to keep an eye on following what could be a pivotal meeting for US monetary policy.
“Goldman Sachs economists believe today’s meeting will provide ‘advance notice’ of tapering, with the language of the statement expected to be similar to that used in July 2017 to indicate the start of balance sheet normalization at the next meeting,” according to the note.
A significant change in the Fed’s policy statement could cause market volatility. Goldman identified four ETFs to watch on Wednesday: the Financial Select Sector SPDR Fund (XLF), the iShares 20+ Year Treasury Bond ETF (TLT), the iShares iBoxx High Yield Corporate Bond ETF (HYG), and the iShares MSCI Emerging Markets ETF (EEM).
These ETFs include bonds or stocks that are highly sensitive to interest rates, which means that a surprise move by the Fed would almost certainly cause a significant change in their price.
According to Goldman, the Financial Select Sector SPDR Fund typically falls after the Fed statement, whereas the iShares 20+ Year Treasury Bond ETF typically rises.
Prior to the pandemic, the iShares MSCI Emerging Markets and iShares iBoxx High Yield Corporate Bond ETFs tended to rise in response to central bank releases, but that hasn’t been the case since March 2020.
When the Fed signaled in July 2017 that it was moving toward tighter policy, the XLF fell while the other three funds rose.
A straddle is one way for investors to prepare for a period of volatility. The options strategy entails purchasing put and call options with the same strike price near the current price of a stock or ETF. If the underlying asset moves more than expected, the trade can be profitable.
“Since the COVID-19 pandemic, equity markets have frequently experienced higher-than-normal volatility on FOMC days,” according to the note.
According to Goldman Sachs, the implied volatility for the XLF in particular appears to be low, making it a potential straddle candidate.
XLF was up 1.9 percent an hour before the Fed’s 2 p.m. ET statement, EEM was up 1.5 percent, and TLT and HYG were up fractionally.
Algorithms drove the Dow Jones sell-off
On Monday, the Dow Jones had its worst day since May, and the Dow Jones Industrial Average dropped more than 600 points. The sell-off occurred as many Wall Street strategists became cautious about the near-term outlook for stocks, with some warning of negative catalysts such as inflation, a slowing in the economic recovery, and Chinese debt issues.
However, Oppenheimer analyst Chris Kotowski stated in a client note on Tuesday that the pullback was due to Wall Street mechanics rather than any macro concerns or underlying issues for the alternative asset management stocks that he closely monitors.
“We don’t believe Mr. Market had a specific fundamental message for us on this particular day. Rather, we suspect that market arbitraging algorithmic strategies hit the sell button on the stocks for some reason, and people scrambled to figure out why,” the note said.
Carlyle Group shares fell nearly 8% in Kotowski’s coverage area, while Apollo Group dropped 7% and KKR dropped 6%. Those were much larger drops than the market as a whole.
Much of the trading in the United States stock market is done almost entirely by computers, which are programmed to make quick moves in order to take advantage of tiny arbitrage opportunities and get in early on trading momentum trends. When enough signals in one direction are received, those algorithms can sometimes cause a large, unexplained movement in a single stock or the broader market.
According to Kotowski, the performance of alternative asset manager stocks provided insight into how the sell-off actually unfolded.
Carlyle and KKR, in particular, are relatively large players in Asia, but have little exposure to the Chinese real estate market, according to Oppenheimer. That would rule out one possible explanation for their underperformance, which is concern about the impact of the Evergrande debt crisis on their portfolios, according to Kotowski. Tax increases proposed by Democrats in Washington appear to be an unlikely reason for the move, he added.
“We don’t see why the ‘Alts’ would have been hit harder than the market as a whole. “We suspect it is more that, even after this move, the stocks are up 55% YTD versus 16% for the Dow Jones, and someone was clearly moving to lock in profits,” the note said.