Interest rate volatility 'went stratospheric' amid monetary policy concerns: Strategist

Cowen Managing Director and Head of Market Strategy Chris Pollard examines the impact of the Fed's interest rate hikes on markets as stocks rally and the economic environment amid inflationary and labor pressures.

Video transcript

- For more on the markets, let's bring in Chris Pollard, Cohen Managing Director, Head of Market Strategy. It's good to see you, Chris. So given that we've seen no data suggesting that inflation is cooled, and we've seen no indication that the Fed is prepared to even pause, they have shown resolve. In other words, what do you make of the market rally for the second straight day to start Q4?

CHRIS POLLARD: Yeah, it's really been something. At the end of the quarter, things got really extreme. And really, before we saw that Bank of England intervention within the gilts market, rate volatility had really gone stratospheric. And that had really influenced cross assets in a global nature.

And one of the things that it really drove was the US real rate market higher, both nominal interest rates to the upside, and importantly, break even inflation expectations to the downside, which definitionally tightened the real rate backdrop. That was terrible for equities. It was terrible for precious metals. And it certainly reverberated with people's thinking around the anticipated growth deceleration coming from policy.

So as we got to the back end of the quarter, the very final few days of the prior quarter and into this quarter, the dampening in rate volatility and the associated moderation in nominal interest rates, and a little bit of a rise in break even inflation expectations actually, largely driven by crude, you've seen real rates moderate a bit. And that's really, in, our opinion helped to fuel the relief in addition to sentiment and positioning extremes that had cropped up in September. Very similar to what we saw at the end of Q2 and following the June FOMC meeting that really brought us to that local low before the summer rally.

- Chris, any reason to think that this bounce that we're seeing over the last two days that it's going to last?

CHRIS POLLARD: In the near term, we certainly think it can last. And as you alluded to at the start at the start of the hour, a lot of the economically sensitive areas that really had let us lower are seeing some relief and are seeing some follow through from what I just pointed to with regards to an engagement to the upside with break-even inflation expectations, maybe a little bit of an incrementally better view on growth. And certainly some of the data that we have gotten suggests that the Fed effect-- the anticipated effect of Fed tightening is starting to work through. We saw lower job openings.

We've seen some moderation in diffusion indices. The ISM data pointed to a bit more softening in the broader economy. And that's what the Fed is trying to accomplish. So certainly, given all of the extremes that we saw at the end of the quarter, and given a dampened cross asset volatility environment, at least at the margin relative to what we saw in September, certainly you could see some follow through. But unfortunately, with the Fed that's targeting a positive real rate regime, and one that's defined by a much tighter real policy rate than we currently have, it's really lowered the equity ceiling. So while we think this can continue in the near term, we are advising clients that as we get closer to the 3,900, 4,000 level, it's time to pare back on tactical exposures because valuations really become much more onerous there, and particularly when you consider the real rate backdrop.

- So Chris, as we take a deep dive into valuations then, what are some of the companies or sectors that you're really keeping an eye on?

CHRIS POLLARD: Sure. I mean, unfortunately, the discretionary areas of the market are really going to be challenged, both with the higher cost of capital and also the unfortunate widening in unemployment that's going to come about with a tightening cycle here. Conversely, we like to focus on classic defensive sectors. Again, we don't think we're out of the woods with this broader bear trend.

We do think ultimately the market will make new lows. Some of that's valuation-oriented and some of that is still residual positioning. Areas like large health care, the utility space are appealing to us, particularly as this market rallies and those areas of the market under-perform in a tactical sense, this is an opportunity to engage there and provide a little bit of insulation in your portfolio before the next down move starts.

- Chris, for a data dependent Fed, there's not a whole lot of numbers to come out between now and November. Friday's jobs number, how could that throw a wrench in their plans?

CHRIS POLLARD: Sure. Look, the data that we've seen on employment up until now still speaks to a tight labor market. Yes, the openings data was a little bit softer this time. But last week's initial claims showed a further deterioration or an improvement in the-- excuse me, the four-week average. And that speaks to still a tight labor market. It's the average hourly earnings number associated with the non-perform report stays sticky or picks up a little bit, that'll be problematic for the Fed's concerns about broader wage price issues, particularly with what's still an impaired labor matching function.

Again, while we did see a moderation in openings, relative to the openings versus unemployed population ratio that was present prior to the pandemic, we're still very elevated from those levels. There's a lot of work to be done. And if there's durability to tight labor conditions, it's going to reinforce the fact that the Fed has more to do and is going to need to stay more restrictive for longer, something that the market seems to be reluctant to really hold on to.

- Definitely one of the stickier challenges for the Fed at this point. A big thank you there, Chris Pollard, for joining us this afternoon--