Wednesday's Market Minute: Setup For A Hawkish Rally

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One of the routines we have on my shows is to do a hypothetical if/then analysis ahead of big events. Yesterday, I posed the question to Prosper Trading’s Scott Bauer: what would happen if Fed Chair Jerome Powell surprised markets with a 75 basis point hike on Wednesday? His response: stock prices would surge.

It may sound crazy based on how stocks have responded to a hawkish Fed the past six months, but the more I thought about it, the more it makes a lot of sense. Generally speaking, the easiest explanation for volatility since the market peaked last November is the Fed’s pivot towards tighter policy. The question is, how do we frame the specific reason why stocks seemingly don’t like those higher rates? Is there just some natural relationship that says stocks should go down because interest rates are going up? Nope. In fact, history suggests quite the opposite: stocks rise as interest rates go up, traditionally.

So are stocks down because the Fed is raising rates too fast? Eh, also not a very good explanation, when you consider the fact that Treasury bond prices and Fed funds futures are actually currently predicting more rate hikes than the Fed has signaled it will do in 2022.

That’s where it gets complicated. Are bond markets pricing in rate hikes because the Fed has said it’s going to raise interest rates, or is the bond market just swinging based on trader speculation about what will happen next? This is essentially the trillion-dollar chicken or egg question: is the tail or the dog doing the wagging when it comes to the market’s implied interest-rate path, compared to the one forecast by policymakers at the central bank?

Here's what we know: the Fed has almost always done what was implied by the market. Right now, the market is expecting 50 basis points on Wednesday and closer to 75 basis points in June. If we accept the common assumption that bond markets are the “smartest” asset class, a different way to frame these expectations is that bond traders are telling us we need a total of 225 basis points of tightening over the next month.

So if the bond market’s the smartest, and the bond market says we need a specific policy change, and Jay Powell adjusts to that request quickly, the logical conclusion would be that he is doing what the economy needs. If the Fed is doing what the economy needs, it makes sense that stocks would rally as they price in a marginally more positive future.

The market sure looks primed for some sort of relief rally. The VIX is already pumped after recent carnage in equities, the dollar is overheated, and the 10-year yield is having some trouble getting through three percent. Not to mention last time the Fed hiked, the market found a short-term bottom. "Short-term" can't be emphasized enough. Even if the market welcomes the Fed's inflation-fighting mantra, it still has balance sheet unwind to deal with, and ultimately, more alternatives to stock speculating the higher yields go.

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.