Market Bulls Are Betting on a Sharp and Shallow Fed Rate-Hike Cycle

(Bloomberg) -- While trying to map the speed of Federal Reserve interest-rate hikes has unleashed harrowing volatility in equities, expectations about the central bank's destination are keeping things from spinning completely out of control.

Despite a series of dramatic repricings following last week's policy meeting, traders still anticipate the Fed's tightening campaign to top out below 1.75% by the end of 2023, according to data compiled by Bloomberg. That's well below the range of 2.25% to 2.5% in the fourth quarter of 2018, a period of far worse turbulence for investors.

A low ceiling for Fed rate hikes, sturdy earnings expectations and still-strong economic growth underlie the stock bull case at the start of 2022. The S&P 500 closed out its biggest two-day rally since April 2020 on Monday, following a week that saw the benchmark post three of the worst intraday reversals of the decade. While the churn is a byproduct of the Fed lifting rates effectively from zero, risk appetites should be OK as long as perceptions hold that the central bank's terminus isn't too high, according to Art Hogan of National Securities.

“If they were to raise rates six times over the next 24 months, we'd get to 1.75% or 2%, that range. That's a very normal fed funds rate,” said Hogan, the firm's chief market strategist. “It's the path to get there that causes the most concern until it starts, and then you see that the sky doesn't fall because they're raising 25 basis points a quarter for the next eight quarters or whatever their cadence happens to be.”

Anticipation of a more-aggressive Fed has especially rattled richly valued technology shares. Yields on two-year Treasuries -- the tenor most sensitive to expected Fed moves -- soared in January, sending the Nasdaq 100 to its worst month since December 2018. However, similar to the S&P 500, the tech-heavy benchmark went on to stage its best two-day rally since November 2020 as dip buyers emerged.

Monday's surge is a blueprint for what's to come should the Fed only raise rates to 2%, according to Independent Advisor Alliance's Chris Zaccarelli. However, faced with the hottest inflation in nearly four decades, he sees policy makers having to hike beyond what markets have penciled in.

Read: Wall Street Splits Over How Far and Fast Fed Acts

“If the fed funds rate stays at 2% or below, then I think the implication for stocks are what you saw on Friday and Monday -- a big rally in risk assets,” said Zaccarelli, the firm's chief investment officer. “Unfortunately, I don't think we're going to be able to tame inflation without going above 2% on fed funds, and so I'll be surprised if we don't see significant volatility for this year and next.”

Of course, the risk remains that should price pressures accelerate, traders have plenty of room to price in a higher terminal rate. While moving aggressively at the start of the hiking cycle should mean that the Fed has to raise rates fewer times overall, that calculation is subject to this quarter's coming inflation prints, BMO analysts wrote in a note Monday.

But stock bulls can take comfort in the fact that inflation expectations have cooled in recent months. Rates on 10-year breakevens are currently trading below 2.5%, down from a peak above 2.75% in November.

Meanwhile, should the Fed hike rates back to 2%, so-called U.S. real yields -- which strip out the effects of inflation -- will still be paltry, according to iCapital's Anastasia Amoroso. That should keep money flowing to technology and growth stocks, given that bonds will likely still offer a negative rate of return. Currently, 10-year real rates clock in near minus 0.71%.

“Despite all the uncertainty about the Fed -- the Fed itself doesn't know how many rate hikes it's going to deliver -- if you take a step back and look at the level of real interest rates, you're still looking at a rate that's less than zero,” said Amoroso, chief investment strategist at iCapital. “That's going to continue to support risk appetite.”