From the Fed to the European currency crisis, here’s what’s behind this sell-off in the financial markets

Trader on the NYSE floor, June 7, 2022.

Source: NYSE

Equities fell sharply, bond yields rose, and the dollar strengthened on Friday as investors listened to the Federal Reserve’s signal that its battle with inflation could result in much higher interest rates and a recession.

Friday’s sell-off was global, in a week when the Fed hiked rates by another three-quarters of a point and other central banks raised their interest rates to fight global inflation trends.

The S&P 500 fell more than 2% to 3,675 on Friday morning and strategists say it looks set to test its June close low of 3,666. The Dow Jones Industrial Average was drifting towards a new low for 2022 on Friday.

European markets fell the most, with the UK’s FTSE and German DAX both down by around 2% and the French CAC by 2.2%.

Weak PMI manufacturing and services data from Europe on Friday and the Bank of England warning Thursday that the country was already in recession added to the downward spiral. The UK government also rocked markets on Friday with the announcement of a plan for large tax cuts and investment incentives to help its economy.

The Fed “approves” a recession

Equities took on an even more negative tone earlier this week after the Fed hiked interest rates by three-quarters of a point on Wednesday and expects it could raise its fund rate to as high as 4.6% by the beginning of next year. That rate is now 3% to 3.25%.

“Inflation and rate hikes are not a US phenomenon. This has also been a challenge for global markets,” said Michael Arone, chief investment strategist at State Street Global Advisors. “It is clear that the economy is slowing down, but inflation is ramping up and the central bank is obliged to deal with it. Pivot for Europe, the ECB [European Central Bank] it is increasing rates from negative to positive at a time when they have an energy crisis and a war in their backyard. ”

The Fed also predicts that unemployment could rise to 4.4% next year, from 3.7%. Fed Chairman Jerome Powell has firmly warned that the Fed will do what it needs to do to crush inflation.

“By basically supporting the idea of ​​a recession, Powell kicked off the emotional phase of the bear market,” said Julian Emanuel, head of equity, derivatives and quantitative strategy at Evercore ISI. “The bad news is that you are seeing and will continue to see it in the short term in the indiscriminate selling of virtually every asset. The good news is that it tends to be that the end game of pretty much every bear market we have ever seen, and it will come in September. and October, where historically it has been the normal state of affairs “.

Concerns over the recession have also pushed the commodity complex lower, with metals and agricultural products selling off across the board. West Texas Intermediate oil futures fell around 6% to just over $ 78 a barrel, the lowest price since the beginning of January.

Europe, sterling impact

As the US stock market opened, Treasury yields fell from their highs and other sovereign rates eased as well. The announcement by the UK government of a radical plan to cut taxes added to the turmoil in that country’s debt and hit the British pound hard. The UK 2-year gilt yielded 3.95%, a rate that was 1.71% in early August. The 2-year US Treasury was at 4.19%, up from a high of more than 4.25%. Bond yields move opposite prices.

“European bonds, while down, are rebounding, but UK gilts are still a mess,” said Peter Boockvar, chief investment officer of Bleakley Advisory Group. “I feel this morning could have been, for the short term, a bond capitulation. But we’ll see. Equities are obviously still very nervous and the dollar is still at the high of the day.”

The dollar index, largely influenced by the euro, hit a new high in 20 years and rose 1.2% to 112.71, while the euro fell to $ 0.9721 per dollar.

Arone said other factors are also at play globally. “China has slowed economic growth through its Covid strategy and common prosperity,” Arone said. “They have been slow to introduce easy monetary policy or additional fiscal spending at this point.”

Arone said that across the world the common threads are slowing economies and high inflation with central banks trying to curb high prices. Central banks are also raising rates as they finish their bond buying programs.

Strategists say the US central bank has particularly rocked the markets by expecting a new forecast of higher interest rates, to the level at which it believes it will stop rising. The high water rate of 4.6% predicted by the Fed for next year is considered its “terminal rate” or final rate. However, strategists continue to see that it is fluid until the course of inflation is clear, and fed funds futures for the beginning of next year were running above that level, at 4.7% on Friday morning. .

“Until we have a picture where interest rates fall and inflation starts to fall, until that happens expect more volatility in the future,” Arone said. “The fact that the Fed doesn’t know where they are going is an uncomfortable place for investors.”

Looking for signs of market stress

Boockvar said the market moves are painful because central banks are having years of easy money, even before the pandemic. He said interest rates were suppressed by global central banks by the financial crisis and until recently rates in Europe were negative.

“All these central banks have been sitting on a beach ball in a swimming pool for the past 10 years,” he said. “Now they’re off the ball and it’s about to bounce pretty high. What’s happening is that developing markets, currencies and debt are trading like emerging markets.”

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he believes markets are starting to price a higher terminal rate for the Fed, up to 5%. “I would say that the forces were unleashed by the Fed by encouraging the market to re-evaluate the terminal rate. This was certainly one of the factors that triggered this volatility,” he said.

A higher terminal rate should continue to support the dollar against other currencies.

“The bottom line is that despite our troubles here in the US, the Fed revising GDP down this year to 0.2% stagnation, we still look like the best solution when considering alternatives,” Chandler said. .

Strategists said they are not seeing specific signals, but are monitoring the markets for any signs of stress, particularly in Europe where rate movements have been dramatic.

β€œIt’s like the Warren Buffett quote. When the tide goes out, you see who isn’t wearing a bathing suit,” Chandler said. “There are places that have benefited from low fares for a long time. You don’t know anything until the tide goes out and the rocks show up.”

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