As Fed sets stage for March rate hike, stock-market investors face perilous backdrop of higher volatility – MarketWatch

Investors, particularly those reliant on computer-generated decisions to buy or sell, face a treacherous backdrop of volatility driven by the Federal Reserve, following a brutal month of stock trading.

January’s violent moves in equities offer a glimpse of what might still be in store: The S&P 500
SPX,
+0.69%

and Nasdaq Composite
COMP,
+0.75%

indexes finished the month with their biggest percentage declines since March 2020, while the Dow Jones Industrial Average
DJIA,
+0.78%

staged an unprecedented 1,214-point reversal in a single day last week. Meanwhile, two- and five-year Treasurys, with rates reflecting the short- to intermediate-term path of Fed policy, are off to their worst start to a new year in more than three decades, according to Dow Jones Market Data.

At issue is uncertainty over just how far the central bank is willing to go to tackle the highest U.S. inflation in almost 40 years, starting with a widely anticipated rate hike in March, investors and strategists say. That uncertainty is, ironically, giving way to at least one area of greater clarity: Big market swings are probably here to stay.

“Volatility is probably the only thing that my compliance department would allow me to guarantee,” said John Lynch, the Charlotte, North Carolina-based chief investment officer for Comerica Wealth Management, which oversees $175 billion in assets. “It could be 15 to 18 months until we get full clarity on the extent of Fed tightening, and the market is susceptible to further bouts until then.”

Meanwhile, “investors need to be prepared for more equity-market volatility, and those caught up in quant or algorithmic trading may get hurt,” he said via phone Tuesday.

Complicating the Fed’s task ahead is a pair of competing forces: One is the likelihood of no near-term letup in inflation, given signs of building price pressures from factors unrelated to U.S. labor and supply shortages. They include strong demand for merchandise and drought conditions outside the U.S. that are driving up the price of commodities like soybeans.

The other force is worries about a potential economic slowdown — as flagged by the International Monetary Fund in January, and the Treasury market, which has flashed repeated warnings about the growth outlook since October. While many say higher inflation makes the case in favor of more aggressive Fed rate hikes, the prospect of a downturn supports the view that inflation could subside and policy makers need to be more cautious about tightening — which, together, are generating even more volatility for financial markets.

The Fed will be “hard-pressed” to lift the fed-funds rate target to its long-run objective of 2.5%, from a current level between 0% and 0.25%, and is more likely to get no higher than 1.5% to 2%, according to Comerica’s Lynch. Despite growing expectations that the Fed could deliver a half-point hike in March, a nonfarm payrolls report that comes below expectations for February might be enough to remove that option, he said.

Add to this environment a continuing debate about the degree to which shrinking the Fed’s nearly $9 trillion balance sheet will tighten financial conditions, or could act as a substitute for rate hikes–a process that some have dubbed as “dual tightening.”

Read: What to expect from markets in the next six weeks, before the Federal Reserve revamps its easy-money stance

In a BofA Global Research note Monday, strategists Andy Pham and Francisco Blanch, along with analyst Chintan Kotecha, wrote that “with risks tilted asymmetrically higher and all but confirmed by the Fed following the January meeting, we think quant investors should brace for a higher vol environment.”

They said they see the backdrop as “perilous,” but say that “pockets of alpha can still be found across commodity and FX risk premia.”

Quantitative systems have been used in recent years as a way to beat the market and post solid returns, while high-frequency trading algorithms have helped to make trading cheaper for many and account for a large portion of the buying and selling of U.S. shares that take place.

U.S. stock benchmarks shook off a tentative start by late Tuesday, with the Dow industrials, the S&P 500 and Nasdaq Composite all posting gains. Meanwhile, Treasury yields were also higher, with the 10-
TMUBMUSD10Y,
1.795%

and 30-year rates
TMUBMUSD30Y,
2.114%

having their biggest advances in almost a week.

“We’re going to see increased volatility among asset classes, and it’s very possible that quant investors would get hit hardest,” said Calvin Norris, portfolio manager and U.S. rates strategist at Aegon Asset Management in Cedar Rapids, Iowa, which oversees $463.8 billion. “I do agree that it will be a long time before we alleviate a lot of the factors causing inflation, and there’s some reason to believe we’re going to see a tailwind from inflation for some time.”

“The pace of Fed rate hikes and the pace of balance sheet runoff, we don’t know. So at this point, the market is left to its own imagination and can spin a hawkish or dovish story for itself,” he said via phone.

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