Did markets overreact to the Fed, and how to trade the BOE meeting

Will stocks continue their decline and how to decide if the Fed is serious about rising inflation risks. 

Financial markets had an abrupt re-set last week after the US Federal Reserve dramatically recalibrated their interest rate expectations and pushed up both growth and inflation expectations. The result was a selloff in global stock markets, with US stocks experiencing their worst week for nearly four months, and the dollar having its best weekly performance since September. The bond market fallout was sharp and shocking, the steepening trade in Treasury yields, when long term yields are higher than short term yields, which has been a market favourite since news about the Covid vaccine in November last year, was dramatically unwound. Longer term yields fell sharply at the end of last week, with the 10-year yield dropping from 1.57% before the meeting to 1.45% at the end of last week. In contrast, shorter term yields surged as investors rushed to price in the prospect of interest rate hikes from the Fed sooner than had previously been expected. The fate of the US yield curve is on everyone’s mind as we start a new week: will the unwinding of the reflation trade continue, or is it a transient phenomenon? Also, will other central banks like the Bank of England who meets this week, follow in the Fed’s footsteps? 

Is the reflation trade dead and buried? 

The market was in a frenzy at the end of last week. Money was being pulled out of “value” stocks that benefit from a low interest rate environment, and being placed into “growth” stocks once more. Although risk appetite was significantly weaker than it has been of late, the Nasdaq outperformed the S&P 500 and the Dow last week. For example, Macy’s, the US department store, fell more than 2% on Friday, whereas Apple’s decline was less than half of that. Added to this, although the S&P 500 fell 1.31% at the end of last week, the Russell 2000, where a large number of value stocks are based, was down by more than 2.2% on Friday. When financial markets are digesting a “shock” from the Federal Reserve, price action can be brutal, but as you can see, some stocks are better protected than others. Amazon and Tesla both saw gains for the week, Amazon was flat on Friday and Tesla rose by more than 1%, as big tech – particularly retail and green energy – acted like a safe haven, seemingly immune from potential US interest rate rises. 

What if the Fed is wrong? 

While the market pounced on the shift in the Fed’s dot-plot, we remain cautious about the outlook, and the current sell-off could be temporary for a couple of reasons. Firstly, Fed chair Jerome Powell said that the dot-plot should be taken with a pinch of salt, and projections were subject to change. There was a whiff about last week’s inflation meeting, that the Fed’s “hawkish” stance was designed to restore its credibility on fighting inflation now that US headline CPI prices are rising at a 5% annual rate. Secondly, inflation and growth may have peaked already, and we could be looking at a disappointing second half of growth in the US and elsewhere, especially since fiscal stimulus is waning, inflation may have peaked and a third wave of Covid could be on the cards. This is an under-priced risk, in our view, especially now that the yield curve has flattened considerably. 

Don’t forget the homebuilders

From a trading perspective we think that last week’s sell off was magnified by high valuations for some stocks, thus we could see the markets pause for breath at the start of this week, as the market waits to see what happens in the bond market before deciding on what could come next for stocks. For example, if the US Treasury yield curve continues to flatten, then we could see more downside for global stocks, however, if long term Treasury yields stabilise, then we may see some bargain hunters come in and buy up some of the worst-hit sectors from last week, including small cap stocks, retail, construction and homebuilders. Interestingly, if you believe that the Fed has jumped the gun and was too concerned about inflation risks at its meeting last week, then you may want to take a look at the US homebuilders, including the S&P home builders index. This sector index has been falling since May, when the US April inflation report came in well above expectations. The prospect of rising interest rates is like kryptonite for home builders, which is why this index has lost more than 8% in the last month, and has massively underperformed the broader S&P 500 index. If the Fed tries to reverse course in the coming weeks, or if inflation pressures start to show signs of waning, then we may see home builders benefit. 

Can hawkish Haldane add more members to his subversive club? 

The Bank of England meeting on Thursday is worth watching closely. No change is expected in the interest rate decision or in the asset purchase facility, however, the minutes from the BOE’s meeting are also released on Thursday, which means that we will get a broader insight into what the BOE is thinking about interest rates and asset purchases in the long term. We think that the BOE may follow the Fed and err on the hawkish side, especially since inflation topped the Bank’s 2% inflation target last month. Added to this, it will be the last meeting for BOE economist Andy Haldane, who was the lone dissenter at the last BOE meeting and who was in favour of reducing the BOE’s asset purchases. Will Haldane have managed to bring some hawks onto his side, especially since the economy is expected to continue to do well even with the delay to opening up the UK’s economy to stage 4? If yes, then we believe that GBP will be the main beneficiary. GBP/USD fell sharply last week as the dollar uptrend gathered pace and as the market reacted to growing Covid infection rates in the UK. EUR/GBP also jumped to its highest level in a week. We do not think that this move in EUR/GBP is sustainable, and the technical indicators also suggest that the trend remains lower for this pair. A hawkish tone from the BOE could see EUR/GBP longs get reversed later this week, with key support at 0.8550 and then back at 0.8450- the low from early April.