Fed Ramps Up Hawkish Talk; Tech Sells Off, Dip-buyers Return

Normally FOMC meeting minutes are somewhat of a non-event as the major insights tend to be communicated during the post-meeting press conference. However, this year we’ve had at least two occasions when the release of the minutes has spooked markets into a risk-off mood.

Yields up, stocks down

A combination of soft PMI data, down to 58.7 in December from 61.1 in November, along with a contraction in JOLTS job openings, caused US markets to sell off on Tuesday, January 4. This set the stage for a more pronounced rout on Wednesday when the minutes were released.

The bond market sold off, which had the effect of spooking tech stocks, particularly as 10-year yields rose to 1.764% for the first time since March of last year. Crypto also took a significant hit; the broad market was down by around 6% on the day as investors with paper profits from 2021 begin to weigh how slowing growth and a more hawkish Fed are likely to dampen the enthusiasm for risk assets.

The S&P 500 was down over 1.8% on the day. The Nasdaq 100 fell by around 2.7%, and the Russell 2000 dropped by more than 3.3%.

Sector rotation?

A great deal has been made recently about the fact that the percentage of Nasdaq 100 stocks that are down by 50% or more from their 52-week highs is almost at record highs. We haven’t seen a situation when so many of the index’s stocks are down despite it trading close to highs since the dot-com bubble of 2000.

The best performing sectors in the first week of January, following the selloff, were Financials and Energy, up 7% and 4% on the week, respectively. This has caused many to speculate about a broader sector rotation. Whether this proves to be the case or not, you can see the market’s concerns present in this mini rotation. Financials are set to perform well in an environment of rising rates. Also, with inflation concerns still front and centre, and the worst of the winter still not over with, energy seems like a smart bet for many investors.

Tech did not actually lead the selloff. Home construction was the worst-performing US sector last week, down 7.8%. Tech was down 3.8% and real estate down 3.3% on the week.

Dip buyers return on Monday

Monday, January 10, saw a substantial gap down across all major US markets on opening. Dip buyers returned en masse to prevent the Nasdaq 100 from enduring a fifth consecutive session of losses. The rally was larger than any such rebound since the depths of the coronavirus crash back in March of 2020. The move would see the Nasdaq 100 alone trading incrementally higher at Monday’s close than it did on Friday’s.

What the minutes said and why it’s a big deal

The offending comments from these particular Fed minutes went as follows:

“…it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate.”

Why was this such a big deal? Because up until now all the talk has been around tapering existing asset purchases and getting to a point where the Federal Reserve can begin to start raising interest rates. These minutes go further than the taper that’s currently underway, or the raising of rates at a faster pace (which the Fed has previously signalled).

December’s minutes suggest that the Federal Reserve is considering putting an end to quantitative easing and replacing it with quantitative tightening (active reduction of the balance sheet). When QE (which is by definition accommodative) goes away, financial conditions necessarily tighten and it’s the prospect of this tightening that financial markets are reacting to.

But it’s more than just that. The famous taper tantrum of 2018 took place as the Federal Reserve was reducing the balance sheet (quantitative tightening) at the same time as raising interest rates. Back then, Powell managed to get the Fed funds rate up to 2.5% before a 20% drawdown in US equity markets caused him to pivot. It’s this combination of balance sheet reduction and interest rate hikes that markets are reacting to.

Data to look out for this week

Wednesday’s upcoming CPI reading should hopefully provide more clarity where inflation is concerned. Also, be sure to keep an eye on the EIA’s crude oil inventory report on the same day, and US initial jobless claims on Thursday.

Final thoughts

The question is how much tightening can equity markets tolerate and where will inflation be once this level is reached? Remember, stocks can rise with a tightening Fed as long as growth levels are maintained. Company earnings will be a key factor to watch this week, as any sharp revisions in growth expectations will get investors’ attention and could result in a further slide for stocks.

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by Giles Coghlan, Chief Currency Analyst, HYCM

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