Stocks won’t bottom until Fed nears end of rate hike cycle, volatility expert says
After a huge two-day surge that kicked off the fourth quarter, US stocks experienced a late-day rally that broke down on Wednesday and sent major indices to a lower finish. And things may not be looking up anytime soon for equities.
Stocks are poised to continue falling as earnings “fall hard” and the Federal Reserve raises interest rates until inflation subsides, according to volatility expert Harley Bassman. Equities “won’t find a bottom” until the end of the Fed’s rate hike cycle — which won’t be until next year, according to policymakers’ projections.
Bassman is best known as the creator of what is now called the ICE BofA MOVE Index, Wall Street’s most-watched measure of fixed income volatility. That index stood at 152.01 on Wednesday, according to Refinitiv – triple what it was last September and above the 150 level that Bassman says is unsustainable “if only because beings humans cannot tolerate such stress for long periods of time.” It has periodically exceeded 150 since July.
Bassman’s views come as the three major U.S. stock indices DJIA,
were unable to sustain a rally in the final hour of trading on Wednesday – after cementing a strong start to the fourth quarter with gains on Tuesday. Meanwhile, hopes of a Fed policy pivot faded after New Zealand’s central bank continued to hike interest rates sharply and US data releases showed the economy remains strong enough for the Fed to continue raising borrowing costs.
Bond market volatility, as measured by the MOVE index, is at its highest level in 13 years, largely due to two important dynamics: the first is that investors continue to sell Treasuries on the likelihood that persistent inflation will lead to continued aggressive rate hikes by the Fed. The other is that the recent bond sell-off is pushing yields to such attractive yields that they are also keeping buyers coming back.
Broadly speaking, Treasury yields have climbed year-to-date toward 4% or more, forcing investors to drive down stock valuations. Such was the case on Wednesday, when the yield on the 1-year note TMUBMUSD01Y,
jumped 14 basis points to 3.96% and rates on 3-month to 30-year maturities all climbed. Bassman warned that rising rates could break the correlation between stock prices and bond yields, the cornerstone of the 60/40 portfolio, as investors simultaneously sell stocks and fixed-income securities.
As US policymakers strive to raise the benchmark US interest rate target closer to the expected level of 4.6% for next year, from a current level between 3% and 3 .25%, “the pressing question is which breaks first: the bond market, the stock market, the housing market, or the economy via rising unemployment,” Bassman wrote.
In a memo filled with colorful imagery, Bassman described Fed officials as being “handcuffed to ‘headline’ inflation, which cannot come down fast enough to stave off further policy tightening.”
Even assuming zero inflation for the rest of the year, he says, the headline annual consumer price index inflation rate is still expected to be 6.5. % in December, based on projections made using data derived from the Cleveland Index. Fed Nowcast estimates. Alternatively, inflation could reach 8.6% in December after taking into account the post-COVID inflation average.
“The Fed effectively bought a seat on the Titanic after it hit the iceberg. Mr. Powell is leading the pack as the market sends rescue flares and we are all wondering who will find a lifeboat,” he wrote.
While not predicting a 1987-type stock market crash, Bassman uses that year to illustrate his point: In October 1987, the Dow Jones Industrial Average DJIA,
fell 22.6% in a single trading session, an event known as “Black Monday”. It was the year the Fed raised the target federal funds rate to above 7%, from around 6%, “with inflation just above 4%,” Bassman said. However, it was the 10-year Treasury yield TMUBMUSD10Y,
advancing to around 10% in October 1987 from around 7% in January of the same year, which “finally broke the market”.
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Meanwhile, other market indicators point to trouble ahead. The spread between 2- and 10-year Treasury yields remains deeply inverted, narrowing to minus 47.5 basis points on Wednesday. And the spread between 5- and 30-year swap rates is screaming “panic,” according to Bassman.
For now, he said, “equities won’t find a bottom until the end of the hiking cycle.” And while Bassman said a crash in bank stocks or real estate prices similar to the Great Financial Crisis isn’t in the cards, “home buying and selling activity is on the cusp. to stop abruptly”.