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

Trader on the floor of the NYSE, June 7, 2022.

Source: NYSE

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

The sell-off on Friday was global, in a week where the Fed raised rates by another three-quarters and other central banks raised their interest rates to counter global inflationary trends.

S&P 500 It was down more than 2% on Friday morning at 3,675, and strategists say it is headed for a test of June’s low of 3,666. The Dow Jones Industrial Average was moving towards a new low for 2022 on Friday.

European markets recorded further decline UK FTSE and the German DAX both down about 2%, and french cac 2.2% off.

weak PMI Data on manufacturing and services from Europe on Friday, and the Bank of England warning on Thursday that the country was already in recession added to the negative spiral. The UK government also shook the markets with the announcement of a plan on Friday comprehensive tax deduction and investment incentives to help your economy.

The Fed is ‘supporting’ a recession

The stock took an even more negative tone earlier this week, after Fed hiked interest rates by three-quarters on Wednesday And there are forecasts that it could raise its funds rate to a high 4.6% by early next year. That rate is now 3% to 3.25%.

“Inflation and rising rates are not a US phenomenon. It has also been a challenge for global markets,” said Michael Aron, chief investment strategist at State Street Global Advisors. “It is clear that the economy is slowing yet inflation is rising and the central bank is forced to address it. Pivot to Europe, ECB [European Central Bank] At a time when they have an energy crisis and a war in their backyard, raising rates from negative to something positive.”

The Fed has also forecast that unemployment could rise from 3.7% to 4.4% next year. Fed Chairman Jerome Powell strongly warned that the Fed will do what it needs What needs to be done to crush inflation?

“By basically backing the bearish view, Powell started the emotional phase of the bear market,” said Julian Emanuel, Head of Equities, Derivatives and Quantitative Strategy at Evercore ISI. “The bad news is that you are seeing and you will continue to see this in the near term indiscriminate selling of almost every asset. The good news is that the end game of almost every bear market we have ever seen, and it is in September and October. Coming to where historically normalcy has been.”

Recession concerns also sent the commodity complex down, with metals and agricultural commodities all selling off across the board. West Texas Intermediate Oil Futures The price, the lowest since early January, fell nearly 6% to just above $78 a barrel.

europe, pound effect

“European bonds, while they are down, are bouncing, but UK gilts are still a disaster,” said Peter Bokvar, chief investment officer at Blakely Advisory Group. “I think this morning there may be a surrender in bonds for the short-term. But we will see. The equity guys are obviously still very nervous and the dollar is still at day’s highs.”

dollar index, substantially affected by euro reached a new 20-year high and was up 1.2% at 112.71, while the euro fell to 0.9721 per dollar.

Aaron said other factors are at play at the world level as well. “China, through its COVID strategy and general prosperity, has slowed economic growth,” Aaron said. “They have been slow to introduce easing monetary policy or additional fiscal spending at this point.”

Aron said that around the world, the common thread is slowing economies and high inflation with central banks engaged to curb higher prices. Central banks are also raising rates at the same time as they are ending bond buying programmes.

Strategists say the US central bank in particular devastated the markets by predicting a new higher interest rate forecast where it believes it will stop hiking. The Fed’s projected 4.6% higher water rate for the next year is considered its “terminal rate,” or final rate. Even so, strategists still see that as a clear liquidity during inflation, and Fed funds futures were running up 4.7% on Friday morning, well above that level early next year.

“Until we get a picture where interest rates come down and inflation moderates, until that happens, expect more volatility,” Aaron said. “The fact that the Fed doesn’t know where they’re going to end up is an uncomfortable place for investors.”

Watching for signs of market stress

Boockvar said the market move is painful because central banks are already shelling out years of easy money from the pandemic. He said interest rates had been suppressed by global central banks since the financial crisis, and until recently, rates in Europe were negative.

“All these central banks have been sitting on a beach ball in a pool for the last 10 years,” he said. “Now they’re getting out of the ball and it’s going to be a lot more bouncy. What’s happening is that developing market currencies and debt are trading like emerging markets.”

Mark Chandler, chief market strategist at Bannockburn Global Forex, said he thinks markets are starting to price up to 5% in a higher terminal rate for the Fed. “I would say the Fed removed forces to encourage the market to reevaluate the terminal rate. That was certainly one of the factors highlighting this volatility,” he said.

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

“The bottom line is, despite our problems in the US, the Fed is revising GDP by 0.2% this year, stagnation, we still look like a better bet when you look at the alternatives,” Chandler said.

Strategists said they did not see any specific signs, but were monitoring the markets for any signs of tension, especially in Europe where rate moves have been dramatic.

“It’s like a Warren Buffett quote. When the tide goes out, you see who isn’t wearing a swimsuit,” Chandler said. “There are places that have benefited from low rates over a long period of time. You don’t know about them until the tide goes down and the rocks are visible.”

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