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

From the Fed to Europe’s currency crisis, here’s what’s behind this sell-off 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 a signal from the Federal Reserve that its battle against inflation could result in 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 inflation trends.

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

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

Weak PMI manufacturing and services data from Europe 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 rattled markets on Friday with the announcement of a plan for sweeping tax cuts and investment incentives to help its economy.

The Fed ‘backs’ a recession

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

“Inflation and rising rates are not an American phenomenon. That 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 forced to address it. Pivot to Europe, the ECB [European Central Bank] is raising the rates from negative to something positive at a time when they have an energy crisis and a war in their backyard.”

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

“Basically, by endorsing the idea of ​​a recession, Powell triggered the emotional phase of the bear market,” said Julian Emanuel, director of equities, derivatives and quantitative strategy at Evercore ISI. “The bad news is that you are seeing it and will continue to see it in the near term in the sell-off of virtually all assets. The good news is that it tends to be that the end game of virtually every bear market we’ve seen, and it will come.” in September and October, where historically has been the normal state of things.

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

Europe, impact of the pound

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

“European bonds, although down, are bouncing back, but UK gilts are still a mess,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I feel like this morning could have been, in the short term, a capitulation in bonds. But we’ll see. Equity rates are obviously still very jumpy and the dollar is still at daily highs.”

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 expansionary monetary policy or additional fiscal spending at this time.”

Arone said that around the world, the common threads 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 they are ending bond-buying programs.

Strategists say the US central bank particularly rattled markets by predicting a new forecast for higher interest rates, to the level at which it thinks it will stop rising. The 4.6% high water rate projected by the Federal Reserve 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 running above that level at 4.7% on Friday morning.

“Until we have a picture where interest rates come down and inflation starts to come down, until that happens, expect more volatility going forward,” Arone said. “The fact that the Fed doesn’t know where they are 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 are undoing years of easy money, even before the pandemic. He said that interest rates have 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 getting off the ball and it’s going to bounce pretty high. What’s happening is developing 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%. “He would say the Fed unleashed the forces by encouraging the market to reprice 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 revised down GDP this year to 0.2%, stagnation, we still look like the best bet when you look at the alternatives,” he said. Chandler.

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

“This is 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 hear about them until the tide recedes and the rocks appear.”

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