The close: Stocks sharply lower after hawkish Bullard spooks investors

The three main Wall Street indexes and Canada’s TSX all finished sharply lower on Friday, after investors were spooked by hawkish interest rate comments by Federal Reserve official James Bullard. The bond market continued to see a dramatic flattening in the yield curve, with short-term rates rising at the same time as long-duration rates went down - a signal that credit players now see a Fed rate hike coming sooner than later which could slow the economy in the longer term.

The benchmark S&P 500 and S&P/TSX Composite indexes, which started the week at record closing levels, slumped after Bullard, president of the St. Louis Federal Reserve, said he was among the seven officials who saw rate increases beginning next year to contain inflation.

Inflation, and how the U.S. central bank will tackle it as the country comes out of the pandemic, had been front-and-center of investors’ minds in the run-up to this week’s Fed policy meeting.

Therefore, since the Fed on Wednesday projected interest rate hikes would happen sooner than previously expected, and signaled it was reaching the point where it could begin talking about tapering its massive stimulus - as opposed to just thinking about it - stocks have struggled.

“I’m not surprised to see the market sell off a little bit. I’m never surprised, given the strong run we’ve had for such a long period of time, when you see some periods of profit-taking,” said Tim Ghriskey, chief investment strategist at Inverness Counsel in New York.

Bullard’s comments spiked the CBOE volatility index, Wall Street’s fear gauge, which initially hit its highest level since May 21, before dropping back a touch.

“Next week, you will have various Fed governors give speeches, and we’ll have the same thing: some governors will be more hawkish, and some will be more dovish, so you’ll see some back-and-forth,” Ghriskey added.

The Canadian benchmark fell 144.45 points, or 0.72%, at 19,999.59. It was the TSX’s worse performance in more than a month. Most sectors were down about 1%, but real estate and tech saw modest gains.

Unofficially, the Dow Jones Industrial Average fell 534.22 points, or 1.58%, to 33,289.23, the S&P 500 lost 56.07 points, or 1.33%, to 4,165.79 and the Nasdaq Composite dropped 131.66 points, or 0.93%, to 14,029.69.

Other market ramifications from Bullard’s comments have included further strengthening of the U.S. dollar. The index which tracks the greenback against six major currencies jumped to its highest level since mid-April, and is on pace for its largest weekly gain in about 14 months.

While U.S. crude prices - which traditionally suffer from a strong dollar - initially fell on Friday, they rebounded after OPEC sources said the producer group expected limited U.S. oil output growth this year.

The August crude oil contract was up 51 cents at US$71.29 per barrel.

The upward commodity move didn’t translate into positive sentiment for U.S. energy stocks, with the sector’s index joining financials as the worst performers.

Friday was also “quadruple witching day,” the quarterly simultaneous expiration of U.S. options and futures contracts which bring about increased trading volume at the market close.

It was the largest options expiration in history, noted Randy Frederick, vice president of trading and derivatives for Charles Schwab.

Long-dated U.S. Treasury yields fell on Friday and the yield curve continued to flatten as market participants bet that the Federal Reserve will act sooner to clamp down on inflation pressures if they persist.

The statement from the Fed Wednesday forecasting two interest rate hikes in 2023 pushed up two-year and five-year yields, which are the most sensitive to rate changes. Long-dated yields, however, have since dropped, led by declines in 30-year bond yields.

Analysts say that many investors are unwinding trades that were betting on higher inflation as the U.S. central bank indicates it will not let price pressures surge as high as some were fearing.

“It does seem as though the market has now shifted its view that the Fed’s going to let inflation run wild, to the Fed’s basically going to kill inflation in the cradle,” said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York, adding that “the truth is probably somewhere in the middle.”

“They are trying to reinforce their control of the narrative. I don’t think they want the narrative to be that the Fed is behind the curve on inflation,” Goldberg said.

Two-year yields rose to 0.2581% after touching 0.284% earlier in the day, which was the highest since April 2020. Five-year yields dipped to 0.8779% after earlier hitting 0.962%, which was the highest since April 5.

Bullard’s comments “are confirmation on the shift at the Fed, which is now more concerned about upside inflationary pressures,” Citigroup analysts Calvin Tse and Kiranpal Singh said in a report on Friday.

The yield curve continued to flatten after Bullard’s comments.

The curve between five-year and 30-year bonds has seen the largest move, flattening to 111 basis points, the smallest yield gap since September. It has flattened from 140 basis points before the Fed statement.

Analysts say the move is being exaggerated by investors unwinding crowded trades betting on curve steepening.

“We think it’s possible long-end steepeners were being used as a positive carry way of positioning for higher yields, especially with the expected Fed liftoff date nearly two years away, and the unwinds of those positions added flattening pressure,” analysts at JPMorgan said in a report on Thursday.

The yield curve between two-year and 10-year notes flattened to 122 basis points on Friday, the flattest since February.

Benchmark 10-year notes were last at 1.445%.

The August gold contract was down US$5.80 at US$1,769.00 an ounce and the July copper contract was down 2.1 cents at almost US$4.16 a pound.

The Canadian dollar traded for 80.52 cents US compared with 81.03 cents US on Thursday.

Reuters, Globe staff

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