(Bloomberg) - Echoing nearly everyone on Wall Street, JPMorgan Asset Management’s Bob Michele and Morgan Stanley’s Michael Wilson are on guard for the potential ripple effects of the Federal Reserve’s so-called quantitative tightening.
This is laid bare in the bond market. Credit spreads, typically the difference between the yield on a corporate bond and the benchmark rate, are still “too expensive,” said Michele, JPMorgan Asset Management’s chief investment officer, on Bloomberg Television Wednesday.
“They don’t seem to adequately price in recession risks. By year-end, they are certainly going to go back up to the old highs of around 600-over,” Michele said. “I also don’t think the markets are adequately pricing in quantitative tightening. That hits in full force next month.”
In September, the Fed is scheduled to step up its balance sheet reduction to a maximum pace of $95 billion -- running off up to $60 billion in Treasuries, and $35 billion of mortgage securities. Since June, the monthly cap has been a total of $47.5 billion. But last month, the Fed only ran down its portfolio by only about $22 billion. This need to tighten policy to rein in surging inflation has been a major headache confronting the Fed.
Wilson, Morgan Stanley’s chief investment officer, in a recent note highlighted that while the Fed stopped tightening its policy before the start of an economic contraction during the past four cycles, triggering a bullish signal for stocks, current historic levels of inflation mean the Fed will likely still be tightening when a recession arrives.
US equities remain stuck in a trading range with the benchmark S&P 500 swinging between gains and losses Wednesday. The benchmark index failed to cross the closely watched 200-day moving average, a technical threshold many see as a signal for a durable uptrend.
“The 200-day moving average is relevant because it is the trend,” Wilson said in the same interview. “So we are in a downtrend, and until the market can get back above that downtrend, I think to be making some grandiose call about new highs is, quite frankly, it’s irresponsible given what’s going on with the Fed and QT coming. It’s going to be a lot worse than people have experienced so far.”
But some Wall Street analysts have begun entertaining the idea that the Fed will stop tightening even as fears of a recession grow. Not Wilson.
“The big change this time versus, say, prior periods when maybe markets got excited about a Fed pivot is this time they’re not going to unless something really bad happens, which of course won’t be good for stocks,” Wilson said. “I just think 15 years of excessive monetary policy has made the average investor sort of complacent around this reality.”
Still, Wilson offered two scenarios in which the central bank may pivot, though underscored that it’s unlikely. Either the US sees a “collapse in inflation” because there’s deflation in many pockets of the economy or the jobs data shows that the nation is in a “full blown recession where companies are really slashing employment.”
“I don’t know where the pain point is on that for the Fed. But they don’t want to drive us into a deep recession,” said Wilson, who correctly predicted this year’s selloff. “But if we got negative payroll data in the next couple of months -- and that’s possible because household data are already negative -- that would be maybe something where they would pause. I don’t think they would start slashing rates, but they can pause. The problem with that narrative for equity investors is that’s not going to be good for earnings. It’s not going to be good for stock prices.”
JPMorgan’s Michele said the central bank should issue more clarity on how hawkish it intends to be in the face of mounting concerns over a recession at the Fed’s much anticipated Jackson Hole, Wyoming, annual event.
“What I hope for at a minimum is that he gives us some metrics about what would it be that would cause them to pause rate hikes and what would cause them to actually start to cut rates,” Michele said, referring to Fed Chair Jerome Powell. “What I think the Fed should be doing and Powell, in particular, is taking the central bank lead on this and make it his moment. For God’s sake, we are the facing highest inflation in 40 years.”
By Isabelle Lee and Jonathan Ferro
