From the Fed to the European currency crisis, this is what lies behind this sell-off in financial markets

Not a bad plan to start hitting the market, says Alicia Levine of BNY

Stocks fell sharply, bond yields rose and the dollar strengthened Friday as investors heeded the Federal Reserve’s signal that its battle with 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 interest rates by three quarters of a point and other central banks raised their own rates to combat global inflation trends.

The S&P 500 closed down 1.7% at 3,693 Friday, after temporarily dropping to 3,647, below its June closing low of 3,666. The Dow Jones Industrial Average ended Friday’s volatile session at 29,890, a loss of 486 points and a fresh low for the year.

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

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

Fed ‘support’ recession

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

“Inflation and rising interest rates are not a US phenomenon. They are also a challenge for global markets,” said Michael Arone, chief investment strategist at State Street Global Advisors. “Obviously the economy is slowing but inflation is picking up and central banks are having to deal with it. Turns to Europe, ECB [European Central Bank] raise interest rates from negative to something positive at a time when they have an energy crisis and war in their backyard.”

The Fed also expects unemployment to rise to 4.4% next year, from 3.7%. Fed Chair Jerome Powell emphatically warned the Fed will do what it needs to do to crush inflation.

“By essentially supporting the idea of ​​a recession, Powell is starting the emotional phase of a bear market,” said Julian Emanuel, head of equities, derivatives and quantitative strategy at Evercore ISI. “The bad news is that you see and you will continue to see it in the near term in the indiscriminate selling of almost every asset. The good news is that the endgame of almost every bear market we have ever seen, and that will come in September and October, in which is historically normal.”

Recession fears also sent the commodity complex lower, with metals and agricultural commodities all selling overall. West Texas Intermediate futures fell about 6% to just over $78 a barrel, their lowest price since early January.

Europe, Pound impact

As the US stock market opens, Treasury yields drop from highs and interest rates in other countries fall as well. The UK government’s announcement of a grand plan to cut taxes added to the country’s debt turbulence and hit British sterling hard. 2-year British Gilt yields 3.95%, a rate that was at 1.71% in early August. The US 2-year Treasury was at 4.19%, down from highs above 4.25%. Bond yields move inversely with prices.

“European bonds, while down, are bouncing, but UK gold is still a disaster,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I have a feeling this morning it might be, in the short term, a capitulation in bonds. But we’ll see. Equity players are obviously still very nervous and the dollar is still at its highs today.”

The Dollar Index, largely influenced by the euro, hit a fresh 20-year high and was up 1.4% at 112.96, while the euro slumped to $0.9696 per dollar.

Arone said other factors also played a role globally. “China through its Covid strategy and shared prosperity has slowed economic growth,” Arone said. “They are slow to introduce easy monetary policy or additional fiscal spending at this point.”

Arone said around the world, the common thread is a slowing economy and high inflation with central banks engaged to curb high prices. The central bank also raised interest rates at the same time they ended their bond-buying program.

Strategists said the US central bank specifically rattled markets by forecasting new higher interest rates forecasts, to levels at which it believes it will stop climbing. The Fed’s projected high water level of 4.6% for next year is considered the “terminal rate,” or final rate. However, strategists still see that as liquid until inflation is clear, and the fund’s futures for early next year are racing above that level, to 4.7% Friday morning.

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

Watch for signs of market pressure

Boockvar said market moves hurt because central banks were releasing easy money for years, even before the pandemic. He said interest rates were pressured by global central banks since the financial crisis, and until recently, interest rates in Europe were negative.

“All of these central banks have been sitting on a beach ball in the pond for the last 10 years or so,” he said. “Now they’re out of control and about to bounce pretty high. What’s happening is emerging markets, currencies and debt are trading like emerging markets.”

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he thinks the market is starting to consider a higher terminal rate for the Fed, up to 5%. “I would say it was the power released by the Fed that pushed the market to change terminal prices. That was definitely one of the factors that unleashed this volatility,” he said.

Higher terminal rates will 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 better bet when you look at the alternatives,” Chandler said.

Strategists say they don’t see any specific signs, but they are monitoring the market for signs of pressure, especially in Europe where interest rate moves have been dramatic.

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