Why investors fear a full-percentage-point Fed rate hike would ‘unnerve’ Wall Street

While fed-funds futures traders overwhelmingly anticipate a hike of 75 basis points, or 0.75 percentage point, on Wednesday, their concern is that last week’s August consumer-price index print, coupled with the still-robust labor market, may have convinced Fed Chair Jerome Powell and other hawks on the Fed’s policy-setting committee that they must do more than simply stay the course as they struggle to curb inflation.

Instead, Fed policy makers may feel they must act more forcefully.

Should this come to pass, it would mark the most aggressive instance of Fed tightening since the days of Paul Volcker, who served as Fed chair from 1979 to 1987, coming on the heels of two 75-basis-point “jumbo” rate hikes, and a 50 basis-point hike in May.

See: The biggest Fed rate hike in 40 years? It could be coming this week.

Many are worried that bringing the hammer down so forcefully would risk unleashing pandemonium across markets by essentially taking the likelihood of a “soft landing” for the U.S. economy off the table. Others are more concerned that failing to bring markets to heel now could risk far worse consequences down the road.

How would markets react?

Sam Stovall, chief investment strategist at CFRA, said in a note to clients that a 100-basis-point hike would represent an “overreaction” on the Fed’s part.

“We think a 100 bps hike would unnerve Wall Street, as it would imply that the FOMC is overreacting to the data rather than sticking to its game plan, and would increase the likelihood that the FOMC will eventually overtighten and lessen the possibility of achieving a soft landing,” Stovall wrote in a note to clients.

With short-term yields already nearing the pressure point around 4%, the always carefully choreographed Fed might not want to risk upsetting markets in such a blithe manner.

See: A punishing selloff in short-term debt is pushing one rate near the ‘magic’ level that ‘frightens’ markets

“The Fed has been telegraphing 75 basis points. If they were to go to 100 basis points, I think it would be shocking to the market,” said David Rubenstein, the billionaire founder of private-equity giant Carlyle Group, said during a Monday interview with Fox Business.

But assuming the Fed does opt for a surprise full-percentage point hike, some can envision a scenario where markets actually rally in the face of a more strident Fed.

“Not predicting this by any means but I could see a scenario where we get 100 and the market actually rallies (after the initial flush) based on the idea that the Fed is ripping the Band-Aid off instead of slowly removing it,” said Matt Tuttle, CEO of Tuttle Capital Management, in an email exchange with MarketWatch.

What’s the point?

To be sure, a 100-basis-point hike is still widely seen as a low-probability outcome. Fed-funds futures markets are presently pricing in roughly 80% odds of a 75-basis-point hike on Wednesday, with odds of a full percentage-point move lingering at 20%, according to the CME’s FedWatch tool.

So far, Japanese investment bank Nomura has been one of the few major sell-side institutions to call for a 100-basis-point hike on Wednesday.

But the argument for why the Fed might decide to deviate from its policy of carefully choreographed moves has clearly resonated with investors, evidenced by the fact that so many Wall Street strategists have chosen to address the possibility in the research they provide to clients and the media.

In a research note published early Tuesday, Nomura cross-asset strategist Charlie McElligott explained why he believes markets are “significantly underpricing” the prospect of a 100-basis-point hike.

His reasoning: Following the latest batch of economic data, Powell simply can’t risk a positive market reaction on Wednesday, since that would lead to a “counterproductive” easing in financial conditions, which happens when stock prices rise and bond yields fall.

If Powell’s aim is to stop inflation from becoming entrenched, he needs to demonstrate that he’s “completely dialed-in on his lone ‘inflation’ mandate hawkishness,” especially as the economic data suggest an incipient wage-price spiral is already taking hold, McElligott wrote.

“100 bps is a necessity to stay front-footed on hitting the demand-side of inflation as hard as possible,” McElligott said in a note to clients on Tuesday.

See: Can the Fed tame inflation without further crushing the stock market? What investors need to know.

What’s the alternative?

If the Fed does deliver a 100 basis-point hike, such an aggressive move would force markets to reckon with the possibility that the fed-funds rate could top 5% next year, which would be anathema to markets and perhaps the economy. This is why JPMorgan Chase & Co. economist Michael Feroli has shied away from making 100 basis points his base case.

See: A surging U.S. dollar is already sending ‘danger signals,’ economists warn

“We think the odds of a 100 basis-point move — though certainly not zero — are lower than a third…good drivers don’t increase their speed as they get closer to their destination,” Feroli wrote in a note to clients published in the middle of last week.

Instead, as Feroli informed JPM’s clients last week, the U.S. megabank expects the Fed to deliver a slightly larger hike in November, along with an additional 25 basis-point hike early next year. The additional 50 basis points of expected tightening would help to bring the upper band of the Fed’s interest-rate target to 4.25% by next spring, which is still much higher than many had expected back in July.

Anything beyond that will be entirely dependent on the state of the economic data.

“If the labor market isn’t materially cooling by Jan-Feb then we’d look for the Committee to continue tightening in 25bp moves until that occurs,” Feroli added.

U.S. stocks were trading lower on Tuesday, with the S&P 500
SPX,
-1.13%,
the Dow Jones Industrial Average
DJIA,
-1.01%
and Nasdaq Composite
COMP,
-0.95%
solidly in the red. Meanwhile, the 2-year Treasury yield
TMUBMUSD02Y,
3.970%
was trading at just under 4%, seen as a level that could create more headaches for the equity market.

See: Why rising Treasury yields are a drag on the stock market