Stocks won’t find bottom until Fed nears end of rate-raising cycle, volatility expert says

After the massive two-day rally that kicked off the fourth quarter, US stocks saw a late-day rally that fizzled out on Wednesday and sent major indexes to a lower end. And things may not get much better for stocks anytime soon.

Stocks are poised to continue trending lower as earnings “are sharply reduced” and the Federal Reserve raises interest rates until inflation eases, according to volatility expert Harley Besman. Stocks “won’t find a bottom” until so close to the end of the Fed’s rate-raising cycle – which won’t last until next year, based on expectations of policy makers.

Basman is best known as the creator of what is now called the ICE BofA MOVE Index, Wall Street’s most widely followed measure of fixed income volatility. That index was 152.01 as of Wednesday, according to Refinitiv — triple what it was last September and above the 150 level that Basman says is unsustainable “just because humans cannot tolerate such stress for long periods of time.” It has periodically crossed 150 since July.

Source: Harley Basman

Basman’s opinions come at a time when all three major US stock indices DJIA,
-0.61%

SPX,
-0.56%

COMP,
+ 11.96%
They were unable to sustain a rally during the last hour of trading on Wednesday – after consolidating a strong start to the fourth quarter with gains. Tuesday. Meanwhile, hopes of a pivot in Fed policy afterwards have faded New Zealand central bank It kept raising interest rates sharply and US data showed that the economy is still strong enough for the Federal Reserve to keep raising borrowing costs.

Bond market volatility, according to the MOVE Index, is at a 13-year high in large part due to two important dynamics: One is that investors continue to sell Treasurys for the possibility that persistent inflation will lead to continued interest rate hikes by the Federal Reserve. The other is that recent selloffs in bonds are driving yields to such attractive yields, and they are also enticing buyers to come back for them.

Overall, year-to-date Treasury yields are up about 4% or higher, forcing investors to lower stock valuations. This was the case on Wednesday, when the yield on the Year 1 bill was TMUBMUSD01Y,
4.195%
It jumped 14 basis points to 3.96% and interest rates on 3-month to 30-year maturities rose. Besman warned that higher interest rates could break the link between stock prices and bond yields, a cornerstone of the 60/40 portfolio, where investors sell stocks and fixed income simultaneously.

As US policy makers press ahead with raising the US benchmark interest rate target near the expected level of 4.6% for next year, from the current level between 3% and 3.25%, the burning question is which will break first: the bond market or the stock market Or the housing market or the economy through high unemployment.

In a note full of color photos, Besman described Fed officials as being “in handcuffs due to ‘key’ inflation, which cannot decline fast enough to stave off further policy tightening.”

Even if one assumes zero inflation for the rest of the year, he says, the annual headline inflation rate from the CPI is still likely to be 6.5% in December, based on forecasts made using data from Cleveland’s Nowcast Federal Reserve estimates. Alternatively, inflation could reach 8.6% in December after factoring in average post-COVID inflation.

Source: Credit Suisse LOCUS Analytics; US Bureau of Labor Statistics; Cleveland Fed Nowcast; Bianco Research

“The Fed actually bought a berth on the Titanic after it hit the iceberg. Mr. Powell leads the band as the market sends out rescue torches and we all wonder who will find a lifeboat.”

While he does not expect a 1987-style stock market crashBasman uses that year to make his point: In October 1987, the Dow Jones Industrial Average DJIA,
-0.61%
It fell 22.6% in one trading session, An event known as “Black Monday”. This was the year the Fed raised the federal funds rate to more than 7% from about 6%, “with inflation barely above 4%,” Besman said. However, the 10-year Treasury yield was TMUBMUSD10Y,
3.815%
It advanced to about 10% in October 1987 from about 7% in January of that year, which “finally broke the market.”

Read also: Wall Street veteran says like slicing bread with a chain saw, Fed still has to do more dirty work

Meanwhile, other market indicators point to problems ahead. The spread between the two-year and 10-year Treasury bond rates is still heavily inverted, narrowing to less than 47.5 basis points on Wednesday. According to Bassmann, the difference between swap rates between 5 and 30 years screams “panic.”

Source: Harley Bassman, Credit Suisse LOCUS

For now, he said, “the stock won’t find a bottom until so close to the end of the hiking cycle.” And while a crash in bank stocks or home prices along the lines of the Great Financial Crisis is not on the cards, Besman said, “the home buying and selling business is on the verge of a complete halt.”

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