Fear of the Fed Resurfaces

Bullish sentiment is rethought as strategists reassess the likelihood of more hikes.
Author:
Publish date:

Wall Street didn't fret Monday as Ben Bernanke took his oath as the new chairman of the

Federal Reserve

. But many traders and investors were likely secretly hoping that Bernanke would give a different pledge, something along the lines of "I solemnly swear not to overshoot."

Fears that the Fed will continue to hike interest rates longer than expected and possibly too much -- to the effect of taking down the economy -- have indeed resurfaced on Wall Street, as noted by several market strategists on Monday.

For example, Prudential Securities' Ed Keon, one of the most bullish market strategists, dampened his enthusiasm. He cut his S&P target to 1350 from 1530 and cut the equity weighting of his recommended portfolio to 55% from 60% previously.

Keon's change of heart came after last week's news of an unexpected drop in fourth-quarter productivity and of strong wage growth in January's employment report. Both reports suggest that rising inflationary pressures from labor costs might lead Bernanke's Fed to lift rates beyond what the market previously expected.

Up until last week, the market clearly expected that after one more rate hike on March 28, the Fed would stand aside with the fed funds rate at 4.75%. But as of Monday, the market was pricing in 40% odds that 5% will be reached at the next Fed meeting on May 10, and 60% odds that this rate will be reached on June 29, according to Miller Tabak. A week ago, the odds of a 5% fed funds rate by late June stood at just 24%.

The stock market's rally in the early part of the January, beyond fresh money being put to work at the beginning of the year, largely happened because the market "saw the light at the end of the tunnel," after 19 months of Fed hikes, says Marc Pado, market strategist at Cantor Fitzgerald. "When that was taken away last week, we saw the market's reaction on Thursday and Friday," as the

S&P 500

dropped 1.4 %.

These concerns, together with another surge in the price of crude oil, still weighed on stocks at the start of the week, with major stock proxies finishing mixed on Monday.The

Dow Jones Industrial Average

rose 4.65, or 0.04%, to 10,798.27. Blue chips were kept afloat by a 4.7% gain in

Alcoa

(AA) - Get Report

, which was upgraded by J.P. Morgan.

General Motors

(GM) - Get Report

rose 0.8% amid speculation it may cut its dividend and put its financing unit GMAC up for sale.

The Dow may also get a boost Tuesday as component

Disney's

(DIS) - Get Report

earnings beat expectations after the close. Disney's shares were recently up 1.8% in after-hours trading.

Meanwhile, the S&P 500 advanced 0.1% to 1265.02 Monday, while the

Nasdaq Composite

dropped 0.2% to 2258.80.

Also Monday, Raymond James' strategist Jeffrey Saut voiced concerns about the Fed's tendencies to "overshoot," raising rates until a financial accident or an economic disaster happens, as mentioned

here.

It's not so much that Saut believes the economic disaster will take place. Instead, he's concerned about market players who had so far discounted an idealistic soft landing for the U.S. economy with the Fed out of the way. If the Fed stays in the game for longer than expected and the economy shows classic spring weakness, these players will drastically review their expectations, and a correction (a 10% drop in major stock proxies) is likely, Saut says.

Likewise, the often cautious market strategist Thomas McManus at Bank of America also said in a research note that the possibility of additional tightening beyond March 28 could lead to "enough of a surprise to the market consensus that its potentially negative impact cannot be overlooked."

Fueling those fears is that the yield curve -- which plots the yields of short- to long-term Treasury maturities -- has again inverted. The yields of long-term bonds are normally higher to reward investors for holding fixed-income assets over a longer period of time. But the yield of a two-year note stood at 4.61% Monday while that of a 10-year bond was at 4.54%.

Often in the past, this inversion has signaled a recession 12 months later, although some economists believe this time is different, because of strong foreign buying of Treasuries and well-anchored inflation expectations in the market.

Whatever its cause, a yield curve inversion slows down risk taking as financial firms lose their normal investment incentive to borrow at cheap short-term rates to invest, or lend, at more expensive long-term rates. "It's not just a one-day yield curve inversion that would do it," says Pado. "This process may take six to nine months, but it's restrictive

to economic growth, no matter how you slice it."

Add to this the possibility of oil prices staying elevated for a while amid geopolitical tensions, and a fourth-quarter earnings season that has so far yielded high-profile disappointments -- such as

Google's

(GOOG) - Get Report

or

Apple's

(AAPL) - Get Report

-- and Pado says a 10% correction is also to be expected fairly soon.

Less than a week after he took over at the Fed, Ben Bernanke is already facing more uncertain times than Alan Greenspan faced in the last two years of his chairmanship.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

click here

to send him an email.