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

Traders on the NYSE floor, June 7, 2022.

Source: New York SE

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

Friday’s sell-off was global, in a week when the Fed hiked rates another three-quarter point and other central banks hiked their own rates to combat global inflationary trends.

That S&P500 was down more than 2% to 3675 on Friday morning and strategists say it appears to be on course to test its June closing low of 3666. The Dow Jones Industrial Average headed for a new closing low for 2022 on Friday.

The European markets declined more sharply UK FTSE and the German DAX are both down about 2%, and French CAC Discount of 2.2%.

Weak PMI European manufacturing and services data on Friday and the Bank of England’s warning on Thursday that the country was already in recession added to the negative spiral. The UK government also rocked markets on Friday by announcing a plan for sweeping tax cuts and investment incentives to support its economy.

The Fed “sanctions” a recession

Stocks took on an even more negative tone after the earlier this week The Fed raised interest rates by three quarters of a point on Wednesday and predicts it could raise its policy rate to a lofty 4.6% by early next year. This rate is now between 3% and 3.25%.

“Inflation and rising interest rates 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’s clear the economy is slowing, but inflation is rising and the central bank is being forced to act. Turn to Europe, the ECB [European Central Bank] is raising interest rates from negative to something positive at a time when they have an energy crisis and a war in their backyard.”

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

“By fundamentally endorsing the idea of ​​a recession, Powell triggered 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 for the foreseeable future, when virtually every asset is sold indiscriminately. The good news is that the endgame of pretty much every bear market we’ve ever seen, and it’s coming in September and October, when historically that’s been the normal state of affairs.”

Recession concerns also sent the commodities complex lower, with metals and soft commodities selling off across the board. West Texas Intermediate Oil Futures fell about 6% to just over $78 a barrel, its lowest price since early January.

Europe, pound blow

“European bonds are rallying as they fall, but UK gilts are still a disaster,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I have a feeling there may have been a short-term bond capitulation this morning. But we will see.

That dollar index, heavily influenced by Euro hit a fresh 20-year high, rising 1.2% to 112.71, while the euro fell to $0.9721 per dollar.

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

Around the world, Arone said the common threads are slowing economies and high inflation, with central banks committed to containing high prices. Central banks are also raising interest rates while ending asset purchase programs.

Strategists say the Federal Reserve particularly shook markets by issuing a new higher interest rate forecast for the level at which it believes it will stop rising. The Fed’s forecast flood rate of 4.6% for next year is considered its “terminal rate” or terminal rate. However, strategists still see this as fluid until the course of inflation is clear, and fed funds futures for early next year raced above this level to 4.7% as of Friday morning.

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

Watch for signs of market stress

Boockvar said the market moves are painful because central banks have been handling easy money for years, even before the pandemic. He said interest rates had been suppressed by global central banks since the financial crisis and until recently interest rates in Europe had been negative.

“All these central banks have been sitting on a beach ball in a pool for the last 10 years,” he said. “Now you get off the ball and it’s going to bounce pretty high. What is happening is that emerging market currencies and debt are trading like emerging market countries.”

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he believes markets are starting to price in a higher final rate for the Fed, up to 5%. “I would say the forces were unleashed by the Fed encouraging the market to reassess the terminal rate. That was definitely 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 to 0.2% this year, the stagnation, we still look like the better choice when you look at the alternatives,” said Chandler.

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

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

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