Stocks could hit new wave of turbulence after 10-year hits key 2% level, Fed rate hikes loom

Published Thu, Feb 10 20225:15 PM ESTUpdated Thu, Feb 10 20226:37 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

The stock market still hasn't found its sea legs after January's wash out, and it's likely to face even more turbulence as inflation sizzles, the Federal Reserve's March meeting looms, and bond yields continue to rise. Stocks sold off Thursday, and the closely followed benchmark 10-year Treasury yield jumped above 2% — an important miles marker — after January's hotter-than-expected consumer inflation report. The consumer price index jumped 7.5% in January, its biggest year-over-year gain since 1982. The 10-year yield rose as high as 2.05%, its highest level since August 2019. But other parts of the yield curve also raced higher. The two-year yield, which most reflects Fed policy, jumped more than 26 basis points, or 0.26%, its biggest move since 2009. "It's definitely a psychological turning point," said Evercore's Julian Emanuel of 10-year yield breaking above 2%. "The investment professional psychology started changing a month ago. But the public psychology is going to start changing now. It's significant." Some bond pros expect the move in the 10-year yield could now cause a reassessment of rate expectations, and that could drive yields even higher. Also on Thursday, the yield curve — the distance between short- and long-duration bond yields — narrowed. A narrowing curve can be a warning of economic stress or, in this case, worries of the Fed's potentially making a policy mistake. Emanuel said the hot inflation report means there could be more volatility around the Federal Open Market Committee's meeting March 15 and 16. Traders in the futures market began to price in more than a 90% chance of a half-point rate hike around that meeting, while economists had been expecting a quarter-point increase. Citigroup economists Thursday were among the first to raise their forecast to a half-point Fed rate hike in March. "Today's inflation print makes the uncertainty band around what the Fed can do and say on March 16 much wider," said Emanuel, chief equity, derivatives and quantitative strategist at Evercore ISI. "That is a recipe for more stock market volatility and a retest of the January low either before or after March 16." If yields continue to rise quickly, that would be difficult for stocks, with technology and growth particularly vulnerable to rising interest rates. The S & P 500 slid 1.8% on Thursday, and the tech-heavy Nasdaq Composite lost 2.1%. The S & P 500 tech sector dropped 2.8%, among the worst performers. Charles Schwab chief investment strategist Liz Ann Sonders said she expects more volatility in both directions as the Fed meeting approaches. "In soft landings, when the Fed has been able to engineer them, even if they're tightening aggressively, the market tends to go through volatile periods," she said. But she noted that, when the Fed has hiked rapidly — with rate hikes at every meeting — the S & P 500 has sold off an average 2.7% in the first year of the tightening cycle. If the Fed raises rates more slowly and skips some meetings, the market does much better and has been higher by an average of 10.5% in those years, she added. The 10-year is key because it influences mortgages and many other consumer and business loans. The 10-year is also an important metric for the stock market because, when it rises, interest rate sensitive groups like tech and high growth, can sell off. Their valuations are based on the prospect of future earnings, and more expensive money makes investors question those valuations. What to do Emanuel recommends investors look to value and cyclical stocks like financials and energy, as the market goes through convulsions. He noted, however, that speculation about a 50 basis-point hike could be problematic. "The problem with 50 basis points is if you do that, you probably also have to do it with the body language that you can do 50 the next time," he said. Emanuel added if the Fed drops the threat of a second 50 basis-point increase, the first would lose its shock value. "The stock market is not at all prepared for it," he said. "The question is there enough buying power in the value names to cushion the blow. The problem is when the market becomes illiquid, and it's been illiquid for weeks, positioning becomes a lot more important. As much buying as there has been of value, people are still underweight it on a longer term basis." Sonders said investors should pick stocks based for their value-like characteristics and stay in quality names. "You get these rip-your-face-off rallies," she said. "Best case scenario, we stay in this environment. Worst case is the market starts to think there's very little chance the Fed can land the plane safely." She also said that even though she does not expect a recession, investors should dust off the recession playbook just in case. Keith Lerner, co-chief investment officer at Truist, said he is looking to cyclical names and also likes some big tech names. "It's part of a barbell strategy with financials and energy on the other side of the barbell because you're going to have a tug of war in Fed policy. If they go faster, what does that mean for the economy," Lerner said. Tech and growth stocks tend to do better when the economy is growing more slowly. Lerner expects the market to continue making adjustments around Fed policy, and with Thursday's inflation report, the view shifted to one of a much more aggressive central bank. "The realistic side is after you had this big bull market and you move past maximum liquidity, we have been expecting more frequent and bigger pullbacks, and part of that is due to the big debate we're having in the first half of this year," said Lerner. "That's what we're seeing with this transition in Fed policy. ... Even though the Fed by most standards is easy, it's the changes on the margin, and the market is digesting this shift."

Traders work on the floor of the New York Stock Exchange (NYSE) on February 04, 2022 in New York City.

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