Beware of these tail events impacting the market!

BNP Paribas strategists have recently warned that investors spend too little time considering tail risks. These are extreme events that are unlikely to occur but would have a significant impact on growth and markets if they do, also known as "gray rhino" events.

BNP Paribas strategists have highlighted some possible extreme scenarios that investors should consider for 2025. Among these, the following three events are the most likely to occur.

The first is a crash in U.S. tech stocks. A team of strategists led by Viktor Hjort, the bank's head of credit research, stated that the seven largest tech giants currently account for 33% of the S&P 500's market capitalization, and valuations are already high. A return to the long-term average price-to-earnings ratio could mean a 30% sell-off.

Hjort and his colleagues said, "We believe that disappointment in the commercialization of general artificial intelligence, efficiency improvements, or revenue growth slowdowns could trigger a sell-off in U.S. stocks. Our economic team's simulations suggest this could push the U.S. into a recession through the wealth effect."

Their reasoning is based on the 2001 U.S. recession, which occurred in the middle of a stock market sell-off from March 2000 to October 2002. They predict a possible 40% correction in U.S. stocks, followed by Federal Reserve action and a decline in U.S. Treasury yields. The ripple effects of a recession would follow with a drop in consumer spending, especially since BNP Paribas notes that households currently hold nearly $60 trillion in stocks.

One way for investors to protect themselves is to buy Nasdaq 100 put spread options, an options strategy that involves taking both long and short positions on the same asset to hedge against a sell-off.

The second gray rhino event is the firing of Federal Reserve Chairman Jerome Powell. Assuming the Fed fails to deliver the significant rate cuts demanded by Trump amid a major stock sell-off or employment slowdown, Powell could be "out." BNP Paribas presents a scenario where a Trump appointee takes over as Fed chair, and all senior Fed officials appointed by Democrats could be quickly replaced.

Although the Fed has "independence" in monetary policy, BNP Paribas points to a recent event. In early January, Trump fired a member of the National Labor Relations Board, which has similar protections against removal as the Fed. The fired official stated she might attempt to have her position reinstated by the courts, which could lead to a Supreme Court ruling on whether Trump can fire officials from other agencies, such as the Fed, BNP Paribas said.

Factors leading to this gray rhino event include tariffs and immigration policies driving inflation higher, forcing the Fed to raise rates, which in turn could lead Trump to worry about the impact of falling stock prices and slowing growth on Republican midterm elections.

Where should investors "hide" in such an event? BNP Paribas suggests that a loss of confidence in the Fed's independence would lead to "abandoning the dollar as the global reserve currency, followed by a massive sell-off of U.S. assets." Among these, the yen could become a safe-haven asset, but a Trump-appointed, more dovish Fed chair would lead to a steepening yield curve, where long-term rates rise faster than short-term rates, as expectations of reduced Fed restrictiveness grow.

The third gray rhino event would be a "Truss moment" for U.S. Treasuries. In 2022, the brief tenure of former UK Prime Minister Liz Truss led to a surge in UK government bond yields and financial market chaos.

Strategists warn that investors might start doubting the sustainability of U.S. finances, "triggering an unlimited rise in U.S. Treasury yields," similar to the Truss crisis, or even worse.

Poor U.S. fiscal discipline and increased issuance could lead to "bond vigilantes" selling off U.S. Treasuries, pushing yields higher, possibly in the third quarter of this year. If inflation has not moved towards the 2% target, the Fed might not intervene to control yields, and the 10-year U.S. Treasury could break 5% and rise to 6%.

BNP Paribas states, "Persistently higher U.S. Treasury yields could also hurt risk asset valuations, particularly U.S. stocks currently at historically high valuations, while overall financial conditions tighten, damaging corporate growth. Of course, the risk-free asset status of U.S. Treasuries could also be compromised."

The dollar might strengthen in such a crisis, but historically high stock valuations complicate the situation for equities.

BNP Paribas strategists add that gray rhino events are not always negative. Other gray rhino events they anticipate include: the disintegration of OPEC+ unity; the Eurozone economy growing by more than 2% this year; the Brazilian market entering a bull market; increased bank non-performing loans due to commercial real estate loans; a default cycle in private debt; and an AI-driven productivity boom in the U.S. economy.