Federal Reserve Chair Jerome Powell is returning to the spotlight this week, with investors anticipating he will begin raising interest rates from near zero to cool inflation being stoked even hotter by Russia’s attack on Ukraine – a step he will be taking amid heightened market volatility.
“Since 1990, the Fed has never started a rate tightening cycle with US equity volatility this high,” said Nicholas Colas, co-founder of DataTrek Research, in a note this week. The central bank may begin hiking rates this week to battle inflation amid higher energy prices, “but it will be in unprecedented territory relative to historical norms.”
The CBOE Volatility Index, or VIX, has closed around 30 or higher every day this month, well above its 200-day moving average of about 20, according to FactSet data. The VIX
was trading above 20 for most of last month and spiked to more than 37 on Feb. 24, when Russia began invading Ukraine, before closing around 30.
Investors worry that soaring commodity prices stemming from Russian President Vladimir Putin’s unprovoked attack on Ukraine could weigh on economic growth, but they have also been concerned that overly aggressive measures by the Fed to tame already high inflation could tip the U.S. economy into recession.
“Usually the Fed is raising rates into an accelerating growth backdrop,” whereas now it may start hiking into decelerating growth, said Emily Roland, co-chief investment strategist at John Hancock Investment Management, in a phone interview. That’s “incredibly challenging.”
But “Powell and company don’t have much choice at this point,” in Roland’s view. “They’ve gotta address elevated inflation even though we are in this period where growth is slowing back down to more modest levels.”
Higher costs for gasoline, housing and food drove U.S. inflation 0.8% higher in February, or up 7.9% from a year ago, according to consumer-price-index data released by the U.S. Bureau of Labor Statistics on March 10. Inflation is now running at the hottest pace since January 1982.
The Ukraine crisis, “with the subsequent increase in commodity prices, has created global economic damage and pressure not just on oil and gas but the entire commodity complex,” said David Lynch, chief investment officer at Cambridge Trust, in a phone interview. “Any hope for transitory inflation, which was already pretty much a lost cause, has certainly become even more so now.”
The Russia-Ukraine war has fueled a rise in the prices in energy, agriculture and metals, with investors concerned about supply disruptions as Russia is a large provider of commodities such as oil, wheat
fertilizer and palladium
They’re monitoring sanctions squeezing Putin, as well as the potential for Russia to restrict its own exports, as these measures could cause inflationary pressures to “heighten and persist for quite a while,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management, in a phone interview.
It’s time for the Fed to “lean against” inflationary pressures by lifting rates from “such rock-bottom” levels, according to Lynch. “They will have to get started” this week, he said, timing that is in line with Powell’s prepared remarks for his testimony before the House Financial Services Committee in early March.
The Fed will conclude its two-day policy meeting on March 16, with Powell then scheduled for a press conference Wednesday afternoon.
Heightened market volatility stemming from Russia’s continued attack on Ukraine isn’t likely to keep the Fed from lifting rates this week, according to Lynch, Roland and Ma, all of whom are expecting the central bank to raise its benchmark fed funds rate by 25 basis points.
Larry Adam, CIO at Raymond James, agrees.
“I would be very surprised if they lifted 50 basis points,” he said in a phone interview. “I don’t think the Fed would want to pile on and surprise the market any more — we’re getting enough” from overseas.
The Ukraine crisis has been roiling the U.S. stock market, which already had been in a slump this year. The S&P 500 index fell into correction territory on Feb. 22. And on March 7, amid high market volatility, the Dow Jones Industrial Average dropped into correction while the Nasdaq Composite slid into a bear market.
The VIX closed at 36.5 on March 7, this year’s peak closing level, FactSet data show.
“Since the modern VIX started life in January 1990,” the index has closed above 36 just 3.8 percent of the time, Colas said in the DataTrek note. By contrast, during the past four rate-hike cycles dating back to 1990, the VIX averaged 17.4 on the day of the Fed’s first rate increase, and slightly below that level in the previous 30 days, according to the note.
“It’s a very volatile market,” said Lynch. “The dust certainly has not settled.”
Russian strikes on western Ukraine Friday pointed to a widening attack, while the U.S. has called for the revocation of Russia’s “most favored nation” trade status, which would allow tariffs to be imposed on Russian imports, according to an Associated Press report. President Joe Biden’s sanctions against Russia have included a ban on importing its oil, as the U.S. aims to deprive Putin of economic resources as he continues to wage war on Ukraine.
The U.S. economy remains strong, even as it slows. “The foundation of the economy is still, I think, robust enough to withstand at least one rate hike to get started,” said Lynch, adding that unemployment is “quite low.” Roland and Adam also pointed to solid U.S. economic growth.
“We still think GDP for this year is going to be 3%,” which is above trend, said Adam. “But we’re watching very closely the impact that these energy prices are going to have on the consumer.”
With average U.S. gasoline prices recently rising above $4 a gallon, Adam told MarketWatch he worries that the pinch at the pump could result in a pullback in consumer spending that represents around 70% of the U.S. economy. “That’s a psychological barrier that I think has the potential to start to alter consumer spending patterns,” particularly if gas prices remain that high through the summer, he said. For low-income earners, that would be “pretty painful.”
“The longer this continues with elevated commodity prices, the greater the probability that we get a more significant slowdown,” said Adam. Oil prices have climbed above $100 a barrel amid the Ukraine crisis, with West Texas Intermediate crude for April delivery
rising 3.1% Friday to settle at $109.33 a barrel.
In U.S. stocks, all three major benchmarks closed lower Friday, booking another week of losses. The Dow
has fallen for five weeks straight, its longest losing streak since the stretch ending May 31, 2019, while the S&P 500
each have dropped for a second consecutive week, according to Dow Jones Market Data.
As for sector allocations in the stock market, Raymond James in the past two weeks or so has downgraded consumer discretionary and communication services to “neutral,” according to Adam. He said that he’s “shying a little bit away from the consumer” and became a bit more defensive with an “overweight” in health care because of the “ripple effect of higher commodity prices” from the Ukraine war.
The U.S. labor market is “strong,” but “the cycle is moving quickly,” cautioned Roland. She described growth as “coming off the boil” after being “turbocharged” by massive fiscal stimulus during the pandemic and “ultra-accommodative” monetary policy, and said the Fed is “behind the curve” in trying to stifle elevated inflation.
The Fed is facing the tough job of trying to “engineer a soft landing” for the U.S. economy as it aims to cool inflation, according to Lynch. “We’re in a deteriorating situation,” he said. “Though the footing is good, it is deteriorating and eroding away.”