Two factors that could make the Federal Reserve do an 'about-face' on interest rate hikes

Published Tue, Mar 8 202212:05 PM ESTUpdated Tue, Mar 8 20221:25 PM EST

The Federal Reserve's plans to raise interest rates could get scuttled due to spiking market volatility and growing pessimism about the economic outlook. Central bank policymakers are widely expected to enact their first rate hike in more than three years next week in an effort to fight burgeoning inflation running at its hottest pace in 40 years . But persistent unease in financial markets , coupled with rising bond market spreads, is helping complicate what is already a difficult calculus for Fed officials. "Since 1990, the Fed has never started a rate tightening cycle with U.S. equity volatility this high," wrote Nicholas Colas, co-founder of DataTrek Research. "The Fed may hike rates next week to combat inflation amid higher energy prices, but it will be in unprecedented territory relative to historical norms." One data point Colas is watching closely is the Cboe Volatility Index, which measures investor fear as expressed through S & P 500 options. The VIX on Monday closed near 36.5, or half a point above what Colas considers a key level. The measure gained roughly 1% late Tuesday morning. One one hand, Colas said this could make an attractive entry point for investors. Since 1990, when the VIX has closed above 36, the S & P 500 is higher 96% of the time on a 12-month horizon, with an average return of 30.1%. On the other hand, it makes for a messy setup for the Fed. In the past four rate-hiking cycles, the VIX has averaged 17.4 on the day of the first increase, or less than half its current level and below the long-standing average closer to 20. Another issue that could cause the Fed to reconsider its course is the spread between yields of corporate bonds and Treasurys. Specifically, the BBB-rated curve, which looks at the lowest-level investment grade bonds versus no-risk government bonds, serves as a policymaking barometer. The ICE BofA BBB option-adjusted spread was most recently at 1.69 percentage points, its biggest gap since November 2020. Wide bond spreads are typically seen as indicators of market fear about growth as bond investors demand higher yields when conditions get riskier. Colas points out that history has shown the Fed reacts when yield spreads hit 2 percentage points, or 200 basis points. The focus is because about half of the $10 trillion corporate debt market resides on that part of the ratings ladder, with a large chunk from the financial sector, which makes up some 24% of outstanding debt. "Keeping the IG corporate bond market functioning smoothly, up and down the credit spectrum, is therefore very important to U.S. financial stability," Colas wrote. "There is a clear call and response between BBB spreads and monetary policy, and this slice of the U.S. investment grade corporate bond market is beginning to flash a warning sign to the" Federal Open Market Committee, he added. "Spreads are widening for the same reasons stocks are dropping: growing concerns over a U.S./global recession caused by spiking oil prices and geopolitical uncertainty." "Simply put, both markets are saying the Fed's belief in a strong Q2 – Q4 2022 US economy is dead wrong," he said. At the end of last year, Fed officials indicated they see GDP growing at a 4% rate through 2022, a view that could get altered at next week's meeting considering the rising inflation tide and impact that the war in Ukraine could have on global growth. For the first quarter of this year, the Atlanta Fed is tracking zero percent GDP growth . That comes amid a bruising inflation picture. Inflation expectations as measured by various bond market gauges are running at 5.24% for the next year, nearly double that of a year ago, according to ICE Benchmark Administration data. Along with the Fed's desire to control inflation, it will have to face substantial downward pressure on growth. Goldman Sachs over the weekend said it sees downside risks to its forecasts of seven rate hikes this year due to a potential "adverse shock to the global economy [which would] will trigger a large tightening in financial conditions that persuades Fed officials to pause (or even reverse) the hikes before too long." "It is too early to say Chair Powell and the FOMC are about to do another monetary policy about-face, like January 2019," Colas wrote, "but that time may be coming very soon indeed."

The Marriner S. Eccles Federal Reserve building in Washington, DC, on January 25, 2022.

Stefani Reynolds | AFP | Getty Images

The Federal Reserve's plans to raise interest rates could get scuttled due to spiking market volatility and growing pessimism about the economic outlook.