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

Trader on the floor of the New York Stock Exchange, June 7, 2022.

Source: NYSE

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

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Friday’s selloff was global, in a week in which the Federal Reserve raised interest rates by another three-quarters of a point and other central banks raised their own rates to combat global inflation trends.

The S&P 500 closed 1.7% lower at 3,693 on Friday, having temporarily dropped to 3,647, below its June closing low of 3,666. The Dow Jones Industrial Average ended Friday’s turbulent session at 29890, a loss of 486 points and a new low for the year.

European markets were lower, with Britain’s FTSE and Germany’s DAX closing down about 2%, and France’s CAC losing 2.3%.

Weak PMI data on manufacturing and services from Europe on Friday, and the Bank of England’s warning on Thursday that the country was already in a recession, added to the negative deterioration. The British government also rocked the markets on Friday by announcing a plan for comprehensive tax cuts and investment incentives to help its economy.

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The Fed “endorse” a recession

Stocks took a more negative tone earlier this week, after the Federal Reserve raised interest rates on Wednesday by three-quarters of a point and predicted it could raise its money rate to 4.6% by early next year. This rate is now 3% to 3.25% now.

“Inflation and higher rates are not an American phenomenon. It has been a challenge for global markets as well,” said Michael Aaron, senior investment analyst at State Street Global Advisors. “Obviously the economy is slowing down, but inflation is going up and the central bank is having to tackle it. Turning to Europe and the European Central Bank [European Central Bank] It raises rates from negative to positive at a time when these people are experiencing an energy crisis and war in their own backyard.”

The Fed also expected the unemployment rate to rise to 4.4% next year from 3.7%. Federal Reserve Chairman Jerome Powell has consistently warned that the Fed will do what it needs to do to crush inflation.

By essentially endorsing the idea of ​​a recession, Powell launched 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 see it and you will continue to see it in the near term in the random selling of almost every asset. The good news is that it tends to be the end game for almost every bear market we have ever seen, and it will come in September and October, which has historically been the norm” .

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

Europe, the impact of the pound

As the US stock market opened, Treasury yields fell from their highs and other sovereign interest rates fell as well. The UK government’s announcement of a comprehensive tax-cutting scheme added to the turmoil in that country’s debt and hit the British pound hard. The yield on the two-year British Treasuries was 3.95%, a rate that was at 1.71% at the beginning of August. The two-year US Treasury was at 4.19%, from a high above 4.25%. Bond yields move the opposite price.

“European bonds, while they are falling, are bouncing, but British bonds are still a disaster,” said Peter Bokvar, chief investment officer at Bleakley Advisory Group. “I feel like this morning it may have been, in the short term, a bond capitulation. But we’ll see. It’s clear that stock guys are still very nervous and the dollar is still at all-time highs today.”

The dollar index, heavily influenced by the euro, hit a new 20-year high and rose 1.4% to 112.96, while the euro fell to $0.9696 per dollar.

Aron said other factors play a global role as well. “China, with its own strategy of Covid and co-prosperity, has slowed economic growth,” Aaron said. “They have been slow to implement easy monetary policy or additional financial spending at this point.”

The common denominators around the world are slowing economies and rising inflation as central banks work to rein in higher prices, Aron said. Central banks are also raising interest rates at the same time they are ending their bond-buying programmes.

Strategists say the US central bank has particularly upset the markets by expecting new expectations for a higher interest rate, to the level at which it thinks it will stop rising. The high water rate that the Fed projects 4.6% for next year is considered the “final rate” or the end rate. However, strategists still see that as bad until the inflation trajectory clears up, and early next year Fed money futures are racing above that level, hitting 4.7% on Friday morning.

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

Monitor market stress indicators

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

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

Mark Chandler, chief market strategist at Bannockburn Global Forex, said he believes the markets are starting to price in a higher interest rate for the Federal Reserve, to 5%. “I would say the forces unleashed by the Federal Reserve to encourage the market to re-price the final interest rate. This was certainly one of the factors that unleashed this volatility,” he said.

The higher interest rate should continue to support the dollar against other currencies.

“The bottom line is that despite our problems here in the US, with the Fed adjusting GDP this year to 0.2%, and recession, we still seem like your best bet when you look at the alternatives,” Chandler said.

Strategists said they are not seeing specific signals, but are watching the markets for any signs of nervousness, especially in Europe where price action has been dramatic.

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

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