Explaining the volatile movements of stocks and bonds this week following the Fed update

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The Federal Reserve has triggered a huge repositioning in global financial markets, as investors reacted to a world where the US central bank no longer guarantees that its policies will be only accommodative – or easy.

The dollar rose the most in a year over a two-day period against a basket of currencies.

Stocks were mixed around the world on Thursday, as were bond markets. Many products have been sold. The Nasdaq Composite was higher, while the S&P 500 and the Dow slipped. Technology won and cyclical stocks fell.

The central bank delivered a strong message on Wednesday when Fed Chairman Jerome Powell said officials had discussed cutting bond purchases and would decide at some point to begin the process of slowing purchases. At the same time, Fed officials added two rate hikes to their forecast for 2023, where there were none before.

“This is the end of maximal pacifism,” said Peter Boockvar, chief investment officer at Bleakley Global Advisors. “It’s not getting hawkish. It’s just that we’ve passed the peak of complacency. This market response is like they’re already declining.”

Strategists say the Fed’s slight move towards tightening policy didn’t shock markets on Wednesday, but it will likely make them volatile going forward. The Fed, in essence, recognizes that the door is now open to future rate hikes.

He is expected to make a more comprehensive statement on the bond program later this year, and then, in a few months, begin the slow process of reducing $ 120 billion in purchases per month to zero.

Yields on shorter duration T-bills, like the 2-year note, rose, while longer-term yields, such as the 10-year benchmark, fell. This so-called “flattening” is a must trade when interest rates rise. The logic is that long-term yields fall as the economy might not fare as well in the future with higher interest rates, and short-term yields rise to reflect expectations of a rise. Fed rates.

Longer-term US Treasuries, like the 10-year, have been lower than many strategists had expected lately. This is in part because they are very attractive to foreign buyers due to negative rates in other parts of the world and liquidity in the US markets. The 10-year rate hit 1.59% after the Fed’s announcement, but fell back to 1.5% on Thursday afternoon. Yields move opposite to price.

Commodity-related stocks, like energy stocks and materials stocks, fell sharply on Thursday afternoon. Among the major sectors of the S&P 500, energy was the worst performer, down 3.5%, and materials were down about 2.2%.

“It’s a massive flattening of the yield curve. It’s an interest rate trade, and it’s the belief that the Fed is going to slow growth,” Boockvar said. “So sell commodities, sell cyclicals … and in a slow growing economy, people want to buy growth. It all happens in two days. It’s just a lot of backtracking.”

Boockvar said the flattening of the curve also happened quickly. For example, the spread between the yield on 5-year bonds and the yield on 30-year bonds quickly narrowed from 140 basis points to 118 basis points in two days.

“You are seeing an incredible unfolding of bond market positioning. I don’t think people thought the Fed would,” said Rick Rieder, CIO Global Fixed Income at BlackRock.

“We thought the trade flattening was the right move when we saw some of the news from the Fed. It’s something we jumped on pretty quickly. I have to say we’re letting some Treasuries go in. this rally, ”Rieder told CNBC.

For equity investors, the change in cyclical stocks works against a trade that was popular when the economy reopened. Financials fell on the flatter yield curve, but REITs were slightly higher. Technology stocks rose 1.2% and healthcare by 0.8%.

“The implication is higher equity market volatility, which I think we are going to have and continue to have,” said Julian Emanuel, head of equity and derivatives strategy at BTIG. “Yesterday changed things. This whole idea of ​​data addiction – the market is going to trade it like crazy, especially since public participation remains very high and the stocks that the public is most interested in are the stocks that are. strong multiple growth which have been in the lead in recent weeks as the bond market remained limited in the range. ”

Even though Powell acknowledged that inflation was higher than the Fed expected, the central bank also insisted that inflationary pressures could be temporary. The Fed raised its forecast for core inflation to 3% for this year, but was only 2.1% for next year, in its latest projections. Powell used the example of rising and falling lumber prices to illustrate his view that inflation will not last long.

But Emanuel said it will be difficult to say whether inflation is fleeting or not, and the economy’s emergence from the pandemic has been difficult to predict. “Whether it’s the Fed or paid economists on the sell side, or paid economists on the buy side, the ability to measure what’s going on in the economy is really nothing more than … everywhere,” Emanuel said, adding that the inflation numbers were all hotter than expected.

He expects the market to be trading within a range for now, with the low at 4,050 on the S&P 500 and the high at 4,250. The S&P 500 closed at 4,221 on Thursday, down 1 point. only. The Dow Jones was 0.6% at 33,823, and the Nasdaq was 0.9% higher at 14,161.

The Fed meeting at the end of July is now looming on the horizon, and that could add even more volatility as investors wait to see if the Fed provides more details on the cut after that meeting. Many economists expect the Fed to use its annual Jackson Hole symposium in late August as a forum to lay out its plan for the bond program.

The bond purchases, or quantitative easing, were initiated as the economy shut down last year in order to provide liquidity to the markets. The Fed buys $ 80 billion in treasury bills and $ 40 billion in mortgage securities each month. Rieder expects the Fed to be able to slow purchases by $ 20 billion per month once it starts to decline. Once the Fed hits zero, it could then consider when to raise interest rates.

Market expectations for rate hikes have increased and the euro dollar futures market is now experiencing four rate hikes by the end of 2023, according to Marc Chandler of Bannockburn Global Forex. Ahead of the Fed’s announcement on Wednesday, futures were showing expectations of around 2.5 rate hikes.

The strategist expects part of the Fed’s reaction to be only temporary and reflect investors who were too far removed from certain positions. “I’m still a commodities bull,” Boockvar said. Commodities had already started falling before the Fed’s announcement, after China announced plans to release metal reserves.

“The Fed had to rule the inflation story. It only did it very, very lightly, but at least it did, and it eliminated the inflation expectations and it saw a pullback.” , did he declare. “The question is whether they get through. Raising rates in two years or dropping it gradually isn’t going to do it, but at least for two days they managed to calm things down.”

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