While bond traders have long been betting on a dovish turn from the Federal Reserve, stock traders have yet to fully embrace this and would fuel an equity rally on such an outcome, according to JPMorgan Chase & Co.’s trading desk.
(Bloomberg) — While bond traders have long been betting on a dovish turn from the Federal Reserve, stock traders have yet to fully embrace this and would fuel an equity rally on such an outcome, according to JPMorgan Chase & Co.’s trading desk.
In laying out its game plans for Wednesday’s policy decision, the firm’s team, including Andrew Tyler, said the “hike and pause” scenario is the most likely — and the S&P 500 could add 0.5% to 1% in its aftermath. The JPMorgan scenarios were issued Monday, right before renewed selling in US regional banks sent equity indexes sharply lower and sparked a rally in Treasuries. Swaps markets continued to show traders betting the Fed will raise rates by a quarter point, though expectations for rate cuts later this year intensified.
The regional banking crisis saw a fourth lender fail on the weekend when the government brokered a sale of First Republic Bank to JPMorgan. Two other banks saw shares slide at least 20% Tuesday as investors worried more troubles lie ahead. Estimates for how the woes will impact lending and act as a brake on the economy vary, but most suggest it will be the equivalent of at least one quarter-point rate hike. The banking turmoil has helped fuel expectations for less central bank tightening.
“Here the Fed would be relying on a tightening of lending standards stemming from the banking crisis to act as de facto rate hikes. Any language that the market interprets as the Fed being on pause should benefit stocks,” the JPMorgan team wrote. “This outcome is not fully priced into equities.”
There are signs that investor angst over macro events such as Fed policy announcements is easing. The Cboe 1-Day Volatility Index, a gauge of implied move for the S&P 500 in the very short term, rose more than 7 points to 17.55 as of 1:30 p.m. in New York. A close around this level would be the lowest reading for any pre-Fed day in the past year, data compiled by Bloomberg show.
Even with other banks potentially wobbling, traders remain laser-focused on Fed policy, especially when the tightening cycle is close to an end. And while no one can forecast with high confidence how markets will react to commentary from Fed Chair Jerome Powell, analysis like JPMorgan’s provides a lens into the risk facing investors.
In what the team considered another high-probability outcome, the central bank could raise interest rates by 25 basis points, as expected by economists in a Bloomberg survey, and leave the door open for more tightening. Any suggestion that the Fed sees additional hikes as appropriate could prompt bond traders to ratchet up wagers on a higher terminal rate and spur an equity pullback that sees the S&P 500 falling 0.75% to 1.25%, the team said.
Pessimism among investors, particularly big-money stock pickers, have persisted despite a rally that has added $5 trillion in equity values since the market’s October low. Part of the bearishness stems from the concern that the Fed’s aggressive tightening could thrust the economy into a recession.
In a situation where the central bank might stop rate hikes this time or even reverse course and cut — a scenario that Tyler and his colleagues viewed as a long shot — stocks could rally initially, only to fade once investors start to ponder whether earlier-than-expected dovishness signals trouble brewing under the surface.
This would likely also mean “more banking crisis contagion is coming,” the team said.
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