From the Fed to Europe’s currency crisis, here’s what’s behind this selloff in financial markets

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

Source: NYSE

Stocks fell sharply, bond yields rose and the dollar strengthened on Friday as investors heeded the Federal Reserve’s signal that its battle against inflation could lead to much higher interest rates and a recession

Friday’s sell-off was global, in a week in which the Fed raised rates by another three-quarters of a point and other central banks raised their own interest rates to combat global inflationary trends.

The S&P 500 was down more than 2.2% at 3,672 on Friday afternoon, after temporarily dipping to 3,662, below its June closing low of 3,666. The Dow Jones Industrial Average was moving toward a new closing low for 2022 on Friday.

European markets fell more, with the UK’s FTSE and Germany’s DAX closing around 2% and France’s CAC down 2.3%.

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

The Fed “endorses” a recession

Stocks took an even more negative tone earlier this week, after the Fed raised interest rates by three-quarters of a point on Wednesday and forecast it could raise its funds rate to a high of 4.6% in early next year. That rate is now 3% to 3.25% now.

“Inflation and rising rates are not a U.S. 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 rising and the central bank is obliged to address it. Pivot to Europe, the ECB [European Central Bank] it’s pushing rates from negative to positive at a time when they have an energy crisis and a war in their backyard.”

The Fed also predicted that unemployment could rise to 4.4% next year from 3.7%. Fed Chairman Jerome Powell strongly warned that the Fed will do whatever it takes to crush inflation.

“By essentially endorsing the idea of ​​a recession, 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 will continue to see in the short term, indiscriminate selling of virtually every asset. The good news is that this tends to be the end game of virtually every bear market we’ve ever witnessed. And it will come. in September and October, where historically this has been the normal state of affairs”.

Recession worries also dragged down the commodity complex, with metals and agricultural commodities selling off broadly. West Texas Intermediate crude futures fell about 6% to just above $78 a barrel, the lowest price since early January.

Europe, free impact

As the US stock market opened, Treasury yields fell from their highs and other sovereign rates also fell. The UK government’s announcement of a sweeping plan to cut taxes added to the country’s debt turmoil and hit the British pound hard. The 2-year British Gilt was yielding 3.95%, up from 1.71% at the start of August. The 2-year US Treasury was at 4.19%, peaking above 4.25%. Bond yields move inversely to price.

“European bonds, while down, are bouncing back, but British gilts are still a disaster,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I think this morning could have been, in the short term, a capitulation in bonds. But we’ll see. The equity guys are obviously still very nervous and the dollar is still at an intraday high.”

The dollar index, heavily influenced by the euro, hit a new 20-year high and rose 1.2% to 112.71, while the euro sank to $0.9721 per dollar

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

Arone said the common threads around the world are slowing economies and high inflation with central banks committed to reining in high prices. Central banks are also raising rates at the same time as they end bond-buying programs.

Strategists say the US central bank particularly jolted markets by predicting a new higher interest rate forecast, for the level where it believes it will stop rising. The Fed’s forecast high-water rate of 4.6% for next year is considered its “terminal rate,” or final rate. However, strategists still see it as fluid until the course of inflation becomes clear, and fed funds futures for early next year were above this level, up to 4, 7% Friday morning.

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

Attention to signs of market stress

Boockvar said the market moves are painful because central banks are recovering from years of easy money, even before 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 swimming pool for the last 10 years,” he said. “Now they’re coming off the ball and it’s going to bounce pretty high. What’s happening is that emerging market currencies and debt are trading like emerging markets.”

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he thinks markets are starting to price in a higher terminal rate for the Fed, up to 5%. “I would say that the forces were unleashed by the Fed encouraging the market to revalue the terminal rate. That 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 problems here in the US, the Fed revising GDP down this year to 0.2%, stagnation, still looks like the best bet to us when we look at the alternatives,” he said Chandler.

Strategists said they don’t see specific signs, but are monitoring markets for any signs of stress, particularly in Europe, where rate moves have been dramatic.

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

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