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Investors fear Fed will tighten rates too far if inflation hits

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Just a few months ago, investors worried that the Federal Reserve was not fighting inflation aggressively enough. Several jumbo rate hikes later, some now fear the Fed will plunge the economy into recession by tightening monetary policy too quickly.

While markets were reeling from last week’s robust inflation rate, late Friday interest rate futures were counting on a roughly 20% chance that the Fed will hike rates by 100 basis points during its Sept. 21 meeting. That number was virtually unimaginable earlier this month as the market wondered whether the move would be 50 or 75 basis points. Investors are also pricing in meatier rate hikes going forward, with the closing rate for US-fed funds now at 4.4%.

While earlier in the year some investors had criticized the Fed for acting too slowly, many are now more concerned that the frenetic pace of rate hikes may not allow policymakers to gauge the effects of monetary tightening on the economy, raising the risk of increases that they raise interest rates too far.

“We all fear too much tightening and the hard landing scenario because the Fed has tightened too much and caused hard landings more often than they haven’t,” said Jeffrey Sherman, deputy chief investment officer at bond fund DoubleLine.

Data from the US shows an economy that appears to be humming along, despite the 225 basis point tightening already delivered by the Fed. Still, alarming signs are easy to spot, from a dire income shortfall from delivery company FedEx that it blamed for slowing growth, to a warning from the World Bank that even a “moderate hit” could send the global economy into recession.

Jeffrey Gundlach, chief executive of DoubleLine, who in June criticized the Fed for acting too slowly, told CNBC last week that he feared the Fed would raise interest rates too far. Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, wrote in a recent LinkedIn post that a rise in interest rates to about 4.5% could plunge stocks by about 20%. The Fed’s policy rate is 2.25 to 2.5%.

“There is an increasing risk that the Fed will … overshoot with rate hikes in response to stubbornly high inflation data,” said Steven Oh, Global Head of Credit and Fixed Income, Co-Head of Leveraged Finance at PineBridge Investments. “That way, they increase the risk of a recession rather than the soft landing they’re aiming for.”

Worries about Fed tightening have already contributed to a 19% drop in the S&P 500 this year. Global bonds have fallen sharply, helped by a sharp sell-off in Treasuries.

Fed Chair Jerome Powell has said that price pressures can be eased without a sharp economic slowdown. However, he has also stressed that the central bank will be relentless in its fight to stamp out inflation.

“Central banks are confronted with much tougher trade-offs. They must choose to live with more inflation or they will kill growth. There’s nothing in between,” said Jean Boivin, head of the BlackRock Investment Institute.

Boivin is underweight developed market equities and does not find government bonds attractive as BlackRock expects the Fed to raise interest rates to 4.50% or higher next year.

“Sharpening too much would come with material economic pain…risk and liquidity stress,” said Daniela Mardarovici, co-head of multisector fixed income at Macquarie Asset Management.

Andrew Patterson, senior international economist at Vanguard, believes it might be better for the Fed to side with aggressive action given inflation persistence. Still, the company sees a 65% chance of a recession in the next 24 months.

Some investors believe the economy is resilient enough to withstand a more aggressive Fed. US employment – an important snapshot of the economy in general – grew faster than expected in August.

“The odds of a soft landing have definitely decreased, but the odds of a hard landing have probably decreased a bit as well,” said Steve Bartolini, portfolio manager for the T Rowe Price US. Core bond strategy.

Market signals were more worrying, however, including the inversions of various parts of the government bond yield curve – a phenomenon that has preceded previous recessions. Forex trading pioneer John Taylor, CEO of Taylor Global Vision, is among the investors who are betting more pain to come in the coming months.

“The stock market is going to be crushed and cause a recession,” said Taylor, who is betting on more declines in the tech-heavy Nasdaq Composite Index. “This is an exaggeration.”

Sherman, of DoubleLine, hopes the Fed will respond to signs of slowing growth, rather than go full steam ahead with rate hikes regardless of the fallout.

“This idea of ​​flexibility, data dependency, that’s what we all want to hear,” he said. “We don’t want to hear the autopilot.”

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