Stock rout is Fed’s ‘best-case scenario’ as Powell-Put era ends
(Bloomberg) — If you’re a Federal Reserve policymaker, the stock selloff of recent weeks comes with a silver lining.
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Financial conditions – a cross-asset measure of market health, from equities to fixed income – have finally started to tighten over the past week in sympathy with the recent fall in stocks, led by technology companies to high prices.
This is likely good news for Fed officials who will meet next week to raise interest rates by an expected 50 basis points for the first time since 2000. In March, Chairman Jerome Powell pointed out that financial conditions are the mechanism by which monetary policy “reaches the real economy”. — and is expected to contract as the central bank raises borrowing costs.
Given this policy objective, the now 12% decline in the S&P 500 this year, combined with the fall in speculative high-growth stocks, can be seen as validation of hawkish monetary efforts to moderate the excesses of this turbulent economic cycle. inflation.
All of this marks the formal end of Powell’s put, or the long-held belief that the central bank will ease all market stress with ever easier policy.
“For the Fed, that’s probably pretty close to the best-case scenario — you’ve had a tightening in financial conditions that has been pretty orderly so far,” said Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors. “Meanwhile, the correction in equities has taken place in the frothier parts of the market and hasn’t had much of a knock-on effect in credit markets despite the wild rate volatility.”
According to a Bloomberg measure, US financial conditions compressed to -0.73, near the tightest levels since 2018, excluding the 2020 coronavirus shock. The measure eased in the aftermath of the meeting from the Fed in March, when policymakers launched the tightening campaign with a 25 basis point hike, undermining their efforts to reduce demand and inflation.
Now markets are less and less buoyant, with rate-sensitive megacaps bearing the brunt of this week’s sell-off as investors brace for wide-ranging Fed hikes. Risk aversion sentiment has seeped into credit markets, where spreads are widening back to March highs but remain near historic lows. Beyond the declines in stocks and bonds, primary markets have tightened for new public stocks and corporate credit, according to Jefferies LLC.
“It should be noted that corporate bond issuance and IPO activity have cooled YTD,” Jefferies strategists led by Sean Darby wrote in a report on Tuesday. “Furthermore, companies seeking second-round funding or that have negative free cash flow have found the reception from financial markets much colder than it was a year ago.”
Even so, the squeeze on financial conditions remains modest, according to SoFi’s Liz Young.
“We’re pretty much back to where we were after the correction at the start of the year and this correction wasn’t too severe given the circumstances,” said Young, head of investment strategy at SoFi. “At least not serious enough to be flagged as a huge risk to financial conditions in the eyes of the Fed.”
All of this suggests that Powell and Co. will eventually have to rise more than expected if the bull market in stocks and credit regains its strength, according to Columbia Threadneedle’s Gene Tannuzzo.
“Tightening financial conditions is the mechanism that reduces demand and ultimately slows inflation,” said Tannuzzo, global head of fixed income at the firm. “If financial conditions don’t tighten and inflation stays high, in their eyes, they need to rise more.”
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