By Davide Barbuscia
NEW YORK (Reuters) - The Federal Reserve's pledge to redouble its inflation-fighting efforts is spooking some investors, who believe it may end up moving too aggressively after moderating its stance a month ago.
Some also worry that the Fed's messaging is becoming erratic as it reacts to successively weak then strong economic data.
Fed Chair Jerome Powell told U.S. lawmakers this week that the central bank would likely need to raise interest rates higher than expected in response to recent economic data that surprised on the upside.
Friday's U.S. employment and next week's inflation report would be key factors in determining whether policymakers would return to jumbo-sized rate increases after scaling back to a quarter-percentage-point hike last month, he said.
Some, however, believe the Fed risks making a policy mistake if it reacts to recent data with larger rate increases instead of waiting for the impact of higher rates to filter through the economy.
"Overall, we believe the Fed is behind the curve," said Jay Hatfield, chief executive and portfolio manager at InfraCap in New York. "It's too hawkish and will overtighten and produce more of a slowdown than is required."
Worries of Fed overtightening are showing up in the ICE (NYSE:ICE) BofA MOVE Index, a measure of expected volatility in U.S. Treasuries that has shot back from a 10-month low and now stands near its highest level since December.
The S&P 500 is down some 3% since Powell's first appearance before lawmakers on Tuesday, though it is still up around 2% for the year. Meanwhile, the inversion of the Treasury yield curve has extended to its widest since 1981, as short-term yields have surged above yields on longer-dated debt - a time-honored recession signal.
Money markets have priced in a return of the Fed to a 50 basis points hike at its next meeting on March 21-22 and a peak of about 5.7% in September, some 20 basis points higher than before Powell's testimony. BlackRock, the world's biggest asset manager, was among the slew of big Wall Street names raising their views for how high policy rates could go, with a forecast of 6%.
Volatility expectations in U.S. Treasuries rise again, https://www.reuters.com/graphics/USA-MARKETS/FED/xmvjkndjgpr/chart.png
For some investors, a return to 50 and 75 basis point rate increases may be a bridge too far.
"Investors fear the Fed is going to overdo it," said Jack Ablin, chief investment officer at Cresset Capital. "It is like if you're turning the hot water on but it takes a while to come through the nozzle .... If you keep turning that dial eventually you are going to burn yourself and I'm afraid the Fed is going to burn us."
While the Fed's words and actions are always closely followed by investors, market participants have been particularly focused on the central bank's response to rising inflation pressures in the economy since the COVID-19 slowdown. Some have criticized it for being too slow in shifting its attention from fighting the pandemic economic shock to controlling prices.
Besides the risks of tightening monetary policy too far, some investors are concerned the Fed may lose investors' trust if it steps up rate increases prematurely, said Troy Gayeski, Chief Market Strategist at FS Investments.
"One risk is that the Fed becomes so reactive to data that they bounce back and forth from 'inflation is a real problem' to 'looks like it's under control,' ... which obviously makes policy much more volatile and leads to more uncertainty," said Gayeski.
Another risk, Gayeski said, is that a run of softer data could prematurely fan risk appetite by convincing investors that inflation was once again on the downswing.
Powell gave that impression to some investors last month, when, during his press conference after February's monetary policy meeting, he repeatedly spoke about signs of "disinflation" that had begun to emerge. A spate of hotter than expected data would soon show that the economy was stronger than the Fed had expected.
The decision to shift to a smaller rate hike in February had followed encouraging data showing a slowdown in price pressures, and a potential return to more sizeable hikes is in line with the Fed's guidance that its decisions would be data dependent.
At the same time, Powell on Wednesday offered some rationale for the benefits of slower rate hikes, saying that, after a year of rapid rises, the economy may still be adjusting.
But some believe shifts in the Fed's view are adding to market uncertainty.
The Fed could enhance credibility with investors by sticking to its view that rates need to remain higher for longer, said Gargi Chaudhuri, Blackrock (NYSE:BLK)'s head of iShares investment strategy for the Americas.
"Instead of the 50 basis points versus 25 basis points ... the real test that the Fed needs to pass in terms of convincing the market (is) that inflation has not significantly dropped enough for us to expect the Fed to begin cutting rates by the end of this year," she said.