Expect a market sell-off so significant that the Federal Reserve will likely "not carry through" with all of its anticipated rate hikes this year, predicts macro investor Felix Zulauf.
"I doubt that they will be as hawkish going through the year as they are saying now," the CEO of Zulauf Consulting told Yahoo Finance.
"My expectation is that we have a sharp sell-off in the markets, maybe 30% from the highs, into the summer, and then the Fed and other central banks will panic," he added.
"In the past, whenever the markets went down by 20%, that was about the pain level when [the Federal Reserve] began to focus on the market," said Zulauf.
"I do believe that that will stop [them] from carrying through," added Zulauf. "Particularly if inflation softens somewhat." The investor expects inflation to temporarily moderate this year, as compared to the last 12 months.
The Federal Reserve is tapering its purchase of bonds in order to combat the highest rate of inflation in over 40 years. The central bank is expected to consider three short-term interest rate hikes starting as soon as March, and debate ways by which it can reduce its asset holdings.
"If they [the Fed] take liquidity out of the system, which they are intending to do by reducing their balance sheet ... I think when they begin to do that, they are probably most likely triggering a major sell-off," said Zulauf.
Once that happens, he predicts the Fed will "turn around and ease again, and they become aggressive to prevent the markets from going further down, a real meltdown."
A Fed reversal will give way to a massive rally after the sell-off, says Zulauf. "That will then trigger another wave up to new highs in 2023 and 2024."
'The darlings usually break last'
"It doesn't show up in the Nasdaq or S&P (^GSPC) because of the — let's call them great eight: the large-cap growth stock darlings. They are still hanging up there, and I think they are building tops," said Zulauf. "The darlings usually break last."
"Once they break, then I think the game changes because they are the assets that are overweighted in virtually every portfolio," he said.
"When you need to sell, because of redemptions as a mutual fund manager, you do not sell your darlings. You sell all the other stocks until you have no choice because their percentage becomes so high that you have to sell them," added Zulauf.
Over the last several weeks, money has flowed more into value and cyclical trades like Energy and Financial stocks. "That will change too," warned Zulauf.
"What I'm describing is really the upcoming unwinding of the inflation trade," which includes rising inflation, low bond yields and rising commodity prices.
"This is all bullish for equities and real assets. And I think the markets in all the asset classes are positioned that way. It's short the bond market, and it's long the equity market. And I think that is going to change," said Zulauf.
On Tuesday, the Nasdaq Composite was hovering near correction territory, down almost 10% from its November high. Tech and internet stocks have been selling off recently as treasury yields have spiked. The U.S. 10-year treasury yield rose to 1.85% on Tuesday, its highest level in two years.
Ines is a markets reporter covering stocks from the floor of the New York Stock Exchange. Follow her on Twitter at @ines_ferre