The eight days that shook the markets

New York Stock Exchange (Reuters)

“I don’t expect moves of this magnitude to be common,” Fed Chairman Jerome Powell said on June 15. The central bank just raised its benchmark interest rate by 75 basis points (0.75 percentage points) to 1.5%-1.75%. This was the third increase in the number of meetings and the largest jump in short-term interest rates since 1994. The move was as predictable as it was surprising. Powell had prepared the markets weeks ago with the expectation of a 50 basis point hike at this policy meeting. But in earlier days, investors quickly and completely priced in an even bigger hike, and more.

Powell’s comment about unusually large increases was enough to cause a partial reversal of the sharp rise in bond yields in previous days and a rebound in stock prices. But As much as I tried to soften the message, rates will go up a lot and chances of a hard landing for the economy will certainly increase as a result. A bigger recession is now expectedif not (yet) by the Federal Reserve, rapid changes in market sentiment show just how much the Fed and other central banks in the rich world have lost control of events.

The Fed’s decision on interest rates came at the end of an unusual few days in financial markets, with bond yields rising at a violent pace, stock prices plummeting, and riskier assets plummeting, notably bitcoin, as well as Italian government bonds. The story did not start in Washington or New York, but in Sydney, where the Reserve Bank of Australia on June 7 raised its benchmark interest rate by 50 basis points, citing rising inflation concerns. The story continued in Amsterdam, where in the following days the European Central Bank (ECB) held its monetary policy meeting, breaking from the usual scene in Frankfurt.. Central Bank President Christine Lagarde has confirmed that a 25 basis point rate hike will take place in July. But it went much further than that. He said the European Central Bank expects to raise interest rates by perhaps 50 basis points in September and Expect “sustainable” rises thereafter. The catalyst for this more aggressive stance was the sharp upward revision of the central bank’s inflation expectations..

A trader works at the New York Stock Exchange (NYSE) in New York City, US, June 14, 2022. REUTERS/Brendan McDermid
A trader works at the New York Stock Exchange (NYSE) in New York City, US, June 14, 2022. REUTERS/Brendan McDermid

This paved the way for a dramatic shift in the bond markets, That events elsewhere added impetus. The yield on German 10-year government bonds, known as bonds, quickly rose to more than 1.75% in the following days. Eurozone riskier government bond yields, especially Italian bonds, rose the most. The spread (excess yield) of Btps on bonds widened sharply, raising Italy’s 10-year yield above 4%. In fact, spreads rose so quickly that the European Central Bank’s rate-setting board held an emergency meeting on June 15 to discuss the matter.

But It was US news that really moved the markets. Figures released on Friday 10 June showed that Annual consumer price inflation rose to 8.6% in May, the highest rate since 1981. Underlying (“core”) price pressures were unexpectedly strong. As if that weren’t enough, a University of Michigan survey showed that consumers’ expectations about inflation in the medium term have increased significantly. Taken together, reports have suggested that It will be difficult to reduce inflation.

Treasury yields rose sharply as the bond market began to expect a faster rate increase from the Federal Reserve. The biggest moves have occurred at the short end of the yield curve, which is most sensitive to changes in monetary policy. Two-year Treasury yields rose 57 basis points in just two days of trading. But long-term prices have also changed (see Chart 1).

shape 1
shape 1

Stocks can’t escape this adjustment (See Figure 2). The S&P 500 index of major stocks fell 3% on June 10 and 4% the following Monday. The accumulated losses have pushed the stock market into bear market territory, defined as a decline of more than 20% from its recent peak. Technology-heavy Nasdaq fell the most. Higher Treasury yields affected stock prices, but it was a boost to the dollar. The dxy, an index of the dollar against six of the rich world’s currencies, is up 10% this year. The strength is particularly noticeable against the yen, which has fallen to a new 24-year low. With the Federal Reserve tightening its policy to cut inflation, the Bank of Japan is aggressively buying bonds to raise it.

Chart 2
Chart 2

The recent volatility, especially in the bond market, has been very severe. What can explain this? As bad as the inflation picture looked before last week, investors took comfort in the belief that the worst was over. Bank of America’s global survey of fund managers indicates that investors have increased their allocations to bonds in recent weeks, perhaps thinking bond prices have stopped falling. (Bond prices move inversely to yields.) If so, the weak inflation numbers surprised them.

A market that tilts strongly in one direction often reverses when the winds change. The lack of liquidity amplifies the effect. Changes in regulations have increased the cost of holding large stocks of bonds for banks to facilitate trading with customers. The Federal Reserve, which has been a reliable buyer of Treasuries, is reducing its purchases. When investors want to sell, very few are willing to accept the other part of the process. The violent market moves in the days leading up to the Fed meeting may have exaggerated the panic.

However, it is difficult to say that investors are optimistic. The Bank of America survey showed that fund managers’ optimism about the economic outlook is at an all-time low. Can emergency landing be avoided? Even Powell seemed unconvinced. Get ready for more trouble.

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