The global stock market could be negatively impacted by FED's rates hike.

Many think that the FED is behind the curve. However, the market can be behind the curve as well, and it appears to be particularly adrift of what is likely to happen with policy rates right now.

Evidence tends to suggest that financial markets underestimate the scale of monetary policy change that is likely to happen in the future. It does not matter whether the central bank is hiking rates or cutting them. If we look at rate expectations, such as fed funds futures, and where the fed funds target actually turns out, we see that markets generally underappreciate how far and how quickly rates will fall in an easing cycle and how quickly and how much they will increase in a tightening cycle.

The miss in market expectations is asymmetrical: traders tend to be caught out more when the Fed is easing than when it is tightening. That’s presumably because policy easing tends to occur very quickly, as it is often driven by an unexpected shock like COVID. In contrast, policy rates tend to rise in a slower and, in some senses, more predictable way. However, it is worth repeating that even if a tightening cycle is conducted in a slow, steady, and predictable way, the market still tends to lag behind. Why is this so? Mr. Steve Barrow, Head of Standard Bank G10 Strategy said one reason is that the market has to learn about the Fed’s reaction function (or indeed, the reaction function of many other central banks, as the likes of the BoE and ECB show similar traits).

Right now, the fed funds futures market, overnight interest swaps, eurodollar futures and more point to the Fed taking rates up to around 2,5% in this tightening cycle. But just as the history, in Mr. Steve Barrow’s opinion, we’ve just talked about suggests that the Fed will end up doing more than this, and probably at a faster pace than anticipated, there are even more reasons to think that the market is behind the curve. For a start, prior tightening cycles going back over the past 20-years or more have taken place against the backdrop of more modest inflation, and the Fed has been able to go slow and steady with rate hikes. That’s not the case now. Inflation is not a potential problem on the horizon but a fact of life now and, as the Fed has suggested, its reaction function will be very different. The market has to learn about this function and, as it is learning, rate hike expectations are being ratcheted higher. But they are still not high enough.

A second issue is that the reaction function of the Fed is different than before because it introduced a new monetary policy strategy in August 2020. This not only seeks an average 2% inflation target, but also is designed to adjust policy asymmetrically. It means that when inflation is consistently below target, the Fed will set policy to produce inflation of at least 2%. But when inflation is consistently above target, the Fed will only seek out a policy that brings inflation back to 2%, not below.

"This would mean that the market stands a better chance of being correct now because the Fed’s underlying monetary policy bias has become more dovish. But we’d argue that this change significantly increases the risk of the Fed making (or continuing to make) a policy mistake that allows inflation to run out of control. If that’s correct, the market might turn out to be even more behind the curve than we thought. And if we had to put a figure on how far the market is behind, we’d say that it is at least 50-bps; more like 100-bps-plus", Mr. Steve Barrow said.