Business
2022.01.12 16:47 GMT+8

Why U.S. stocks look more vulnerable than in previous Fed tightening cycles

Updated 2022.01.12 16:47 GMT+8
By Jimmy Zhu

Editor's Note: Jimmy Zhu is chief strategist at Singapore-based Fullerton Research. The article reflects the author's opinion, and not necessarily the views of CGTN.

Unlike the Federal Reserve's (Fed) previous tightening cycles, U.S. stocks may have a tougher time in the coming months, as a rising bond yield is likely to induce traders to dump more tech stocks, weighing on broader market sentiment.

The U.S. 10-year government bond yield climbed above 1.8 percent on January 10. It was near 1.5 percent at the beginning of the year. The rapid growth reflects that the fact that investors are selling those bonds quickly due to persistent rising inflation and Fed's policy to be much more hawkish than the market had expected.

Some indicators suggest that global inflation has yet to reach peak levels. JP Morgan's global composite PMI slowed to 54.3 last month, suggesting that factory and consumption demand has been easing. However, commodity prices rose 3.5 percent in the same month. The divergence between the PMI and commodity prices could be explained by supply chain shortages deteriorating due to the wide-spreading Omicron variant.

On the other hand, evidence shows that wage growth in the U.S. may further accelerate as the labor market tightens. The U.S. added only 199,000 jobs in December, the slowest pace in 2021, while the unemployment rate dipped to 3.9 percent, the lowest reading since the pandemic started in the U.S. in early 2020. Slower job creation with a low unemployment rate means companies will find it more difficult to recruit suitable employees, putting pressure on wage growth to accelerate further.

In order to curb the persistent inflation pressure, the Fed has decided to accelerate the pace of tightening. According to the Federal Open Market Committee's December meeting minutes, the central bank is expected to raise the benchmark rates by three times in 2022, and the first hike may happen as early as March.

In his confirmation hearing before the U.S. Senate Committee on Banking, Housing and Urban Affairs, Fed chairman Jerome Powell said he expects a series of interest rate hikes this year, alongside a cutback in the extraordinary help the Fed has provided during the pandemic era.

He added that if inflation persists at high levels longer than expected, the central bank would have to raise interest more over time, and he pledged to use tools to peg inflation back in that case.

Bond market continues to rattle U.S. stocks

U.S. stocks are expected to face more volatility amid the upcoming Fed tightening cycle as the bond yield rattles. Some investors may argue that higher rates usually stand for a strong economy, so it's not a bad event for stock markets. However, the situation is pretty different today. The trillions of liquidities pumped in by the Fed since the pandemic began in early 2020 boosted growth-oriented stocks, typically in tech sectors, and gains in those mega-tech stocks pushed the broader market higher.

Most of the top 10 stocks in the S&P 500 index, by market capitalization, are tech stocks, and they make up 28.5 percent of the index's market value. This means changes in these stock prices will easily drive the direction of the broader market. However, the current higher bond yield outlook means future profits are worth less today, and that's hurting fast-growing technology stocks.

Another indicator may induce investors to sell more tech stocks because they may be too expensive at the moment. The Nasdaq composite index to Dow Jones ratio now stands at 0.413, almost the highest since 2000, when the dot-com bubble burst. History is not necessary to repeat for this time, but extremely expensive tech stocks with a background of a higher interest rates outlook have already warned traders to stay cautious, as the Nasdaq composite index dropped 4.5 percent in the first week of 2022.

On the other hand, the current level of the dollar index, hovering around the 95.6 level, has yet to reflect the Fed's upcoming hawkish approach. The currency is likely to trend higher in the coming month once more investors believe that the first rate hike will happen in March. A higher dollar tends to pressure U.S. stocks lower; the negative correlation between the dollar index and S&P 500 stood at 0.78 in the past 12 months.

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