The fear of rate hikes ahead of the Fed meeting is causing investors to hoard cash, flashing a contrarian 'buy' signal for stocks, Bank of America says

• Investors' fear over potential interest rate hikes by the Fed surged in Bank of America's latest fund manager survey.
• The fear of hawkish central banks has sparked a jump in cash raising by investors, creating a contrarian buy signal.
• "Investors [are] very cautious but few [are] outright bearish," Bank of America said.

Investors are growing fearful of a potential policy shift by the Federal Reserve, according to Bank of America's latest fund manager survey.

The Fed is expected to speed up the pace of tapering its monthly bond purchase program when it wraps up its policy meeting on Wednesday, and it could also signal when it might finally begin to raise interest rates in 2022 to help tame inflation.

Interest rate hikes would serve as a shock to some investors who have been conditioned to expect ultra-easy monetary policies from the Fed ever since the onset of the COVID-19 pandemic in March 2020. But with the Fed funds rate currently at 0% to 0.25%, there is plenty of room for the Fed to raise interest rates.

For the first time since May 2018, fund managers now see Fed tightening policies as the No. 1 tail risk, according to BofA's survey. The central bank raised rates four times in 2018 to 2.50%, and fears of the Fed tightening too much led to a sizable stock market decline in December 2018.

But the stock market has a history of generating positive returns amid Fed interest rate hikes, and a recent surge in cash allocations among fund managers is flashing a contrarian buy signal, according to the note.

"Hawkish central banks spark surge in cash and more defensive asset allocation," BofA said. Cash allocations jumped from 4.4% in November to 5.1% in December, triggering a buy signal that has historically generated six-month equity returns of 6.5% on average.

And if the Fed comes off as dovish during its meeting this week, signaled by either no acceleration of its tapering program or later-than-expected guidance for rate hikes, BofA expects a rally to materialize in crypto, unprofitable tech companies, and banks.

Other top tail risks noted by fund managers include inflationary pressures and a potential resurgence in COVID-19. Meanwhile, the most crowded trades among fund managers include long US tech stocks, long bitcoin, and long ESG, according to the survey.