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Fed: ‘There’s a disconnect’ between bank and market expectations, strategist says

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DailyFX.com Senior Strategist Christopher Vecchio joins Yahoo Finance Live to discuss recent stock market dip as U.S. inflation reaches a 39-year high, global spare oil production capacity, bitcoin's correlation with the S&P 500, and the U.S. Dollar Index climbing to a new high for the first time since July 2020.

Video transcript

[MUSIC PLAYING]

BRIAN SOZZI: The S&P 500 and Dow are tracking toward their fourth straight weekly losses as investors brace for a series of interest rate hikes later this year. Earnings season hasn't been amazing either, excluding Apple, of course. More insight into the market action. We're joined by DailyFX.com Senior Strategist, Christopher Vecchio. Chris, always nice to see you. Hot note out this morning here from Bank of America looking for 7% interest rate hikes this year. Is this the type of note that you think could spook investors out of the market?

CHRISTOPHER VECCHIO: I do think that some investors will take this and see it as a sign that the tides have turned quite dramatically, with respect to expectations around Fed policy. As it were the market itself when you look at a variety of measures of their eurodollar futures contracts, if you're looking at Fed funds futures, we're still talking about closer to four rate hikes priced in for 2022.

So the fact of the matter is that there is this disconnect between what some banks are saying, and banks talk in their book in part because net interest margin increasing would be beneficial for their bottom line. But there is a disconnect between what banks are predicting and what the market itself is actually predicting.

I'd like to point out, though, historically speaking, the market's been pretty rubbish about predicting which way the Fed is going to go. Always too aggressive or too dovish, it's never in that Goldilocks zone where it ends up nailing the actual path of interest rate hikes. So I would suggest that as the data evolves, as we move forward through this year, the sensitivity to inflation, and more importantly, to those supply chain issues will largely dictate how fast the Fed moves.

And without additional QE, without any additional fiscal stimulus, the global credit impulse is set to fade rather quickly. This is not just due here to the United States, but what's happening abroad with Europe, with the UK, with Canada, and ultimately that means that we could be looking at inflation pressures relieved very dramatically in the second half of 2022.

JULIE HYMAN: Well, that would imply that perhaps the market is too hawkish when it comes to what is pricing, and as you say, if the market tends to get it wrong. As you look across asset classes, is there anything that seems appropriately priced at these levels, whatever appropriately priced means right now?

CHIRSTOPHER VECCHIO: Yeah. I think that energy is off to a great start this year and continues to have a robust bull case for it, not just because of some of the headlines that we're seeing and hearing out of Eastern Europe, with respect to Russia and Ukraine, but this is a sector where they really unloaded a lot of their debt burden in recent years. They've had to deleverage as a result of the big energy come down in 2014, 2015. And there isn't much spare capacity right now.

So there is a high supply demand in balance in favor of demand outstripping supply. Earnings should continue to improve for some of these energy producers, ETFs like XLE and XOP, a great start relative to the broader market this year. And I think that's a one place that traders can look, or investors can look right now to see continued outperformance here as we make our way through the early parts of 2022.

JULIE HYMAN: I mean, it is interesting because, to your point, we already have seen energy do so well in 2021. We've got the likes of Goldman Sachs out with a call on oil of, I believe, $101 a barrel. Does something like that seem reasonable to you and are we going to see energy stocks and the XLE kind of beat for beat go along with what we could see from oil prices?

CHIRSTOPHER VECCHIO: Sure. I do think that's a reasonable prediction. In part because OPEC plus just hasn't restarted its production in the manner that a lot of people were expecting thus far. And we need to consider the fact that a lot of these OPEC plus countries, they don't levy significant taxes on their citizens, they derive a lot of their government revenue from the activities in the energy market.

So the fiscal break, even for oil prices for a lot of these countries, is above $90 a barrel right now. They have every incentive in the world to continue to constrain supply so that oil prices can continue to march higher. And given the way that demand has been shaping up and as vaccinations spread, global economic growth will continue to kick in as a key driver here.

One of my favorite stats about the oil market is if you look back over the past 30 years, the correlation between quarterly global GDP and global oil demand is a robust 0.97. So as vaccination spread as emerging markets get their hands on vaccines, it's good news for oil demand, good news for oil prices.

BRIAN SOZZI: Chris, let's stay on correlations since you brought it up. One chart I am watching is cryptocurrencies versus the S&P 500. And you can very clearly see that they're trading pretty much in line. And this just pokes a hole, I think, in this notion that crypto is some type of inflationary hedge. I mean, look at that chart. I mean, clearly that's not the case, clearly the market views it as a very risky asset in the same basket as a tech company that's not making any money.

CHIRSTOPHER VECCHIO: No. And given the fact that we've seen a decoupling of Bitcoin from inflation expectations over the past three or four months, and becoming more highly correlated with the S&P, in particular with the NASDAQ and those tech stocks, Bitcoin's behaving more like a high duration asset, a long duration asset.

And, as we know, long duration assets tend to underperform most significantly in environments when interest rates rise. So as far as I'm concerned, Bitcoin prices still are vulnerable here for more downside, as are Ethereum, as are really any cryptocurrencies because the NASDAQ is still vulnerable right now in this rising rate environment.

I do think that we could be looking at a washout point, however, when we get to the March Fed meeting when we finally get on with the rate hikes. Coming into this year, as we discussed at the end of 2021, I didn't think that we're going to have a good first half of this year in equity markets. And that necessarily spills over to Bitcoin and to Ethereum as well. So more downside could be ahead here. I know people will come on and accuse me of having FUD, fear, uncertainty, and doubt, but this is a bigger macro story that's unfolding at present time.

JULIE HYMAN: God forbid one is a crypto skeptic at this point in time, or even crypto cautious person, forget about skeptic. As we talk about Bitcoin, I'm curious about actual gold versus digital gold, right? It had been rallying a little bit, but has since come down. And then I got to consider the US dollar too, which has been moving higher. So I guess in other words, if you're looking at cryptocurrencies, gold, and the dollar on a relative basis, what do you pick?

CHIRSTOPHER VECCHIO: Well, I think the dollar is in great shape right now in part because rising real yields continue to evolve. When we look at what's been happening at the US Treasury Yield Curve recently, short end rates have been rising faster than long end rates, a flattening yield curve, which has been consistent with other Fed QE unwinds and rate hike cycles that we've seen over the past decade.

But more importantly, we've also seen inflation expectations start to edge down meaningfully. If you look ahead at the five year, five year, you're talking about a 40% basis point decline in forward-looking inflation expectations over the past three months. And so, real yields are starting to ratchet up.

And as real yields go up, gold, which doesn't have a dividend coupon cash flow, any sort of stream of payments, it loses appeal in this kind of environment. So gold and Bitcoin don't really look like they're in favor right now. I think that the US dollar still has much more upside ahead of it over the course of the next few months. While there is a very large crowded net long position in the futures market, this could merely be a temporary headwind, but ultimately the dollar index looks like it's on a path towards 100 or so.

BRIAN SOZZI: Christopher Vecchio, DailyFX.com, Senior Strategist, always good to see you. Have a good weekend.

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