From the Federal Reserve to Europe’s currency crisis, here’s what’s behind this selloff in financial markets

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 selling was global, with the Fed raising interest rates by another three-quarters of a point during the week and other central banks raising their rates to combat global inflationary trends.

The S&P 500 fell 1.7% to 3,693 on Friday after temporarily dipping to 3,647, below a June low of 3,666. The Dow Jones Industrial Average ended Friday’s choppy session at 29,890, a 486-point loss and a new low for the year.

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

Adding to the negative spiral on Friday were weak European PMI data on manufacturing and services and a Bank of England warning on Thursday that the country was already in recession. The UK government also rattled markets on Friday with the announcement of a massive tax cut and investment stimulus plan to help its economy.

Fed “confirms” recession

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

“Inflation and rising interest rates are not a US phenomenon. It has been a challenge for global markets as well,” said Michael Arone, chief investment strategist at State Street Global Advisors. “It is clear that the economy is slowing down, but inflation is accelerating and the central bank is forced to deal with it. Pivot to Europe, ECB [European Central Bank] raising interest rates from negative to positive at a time when they have an energy crisis and war in their backyard.

The Fed also projected that unemployment could rise to 4.4% from 3.7% next year. Federal Reserve Chairman Jerome Powell has adamantly warned that the Fed will do everything in its power to suppress inflation.

“By essentially supporting 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 this in the near term in indiscriminate selling of almost all assets. The good news is that the end game of almost every bear market we’ve witnessed, and it’s coming in September and October, where historically it’s been normal state of affairs.”

Recession worries also turned the commodity complex lower, as metals and agricultural products sold off broadly. West Texas Intermediate crude futures fell about 6% to just above $78 a barrel, the lowest since early January.

Europe, pound effect

As the US stock market opened, Treasury yields fell to their highest levels and interest rates on other government bonds also fell. The UK government’s announcement of a massive tax cut plan increased the country’s debt burden and dealt a heavy blow to the British pound. The 2-year British Gilt yielded 3.95%, up from 1.71% in early August. The US 2-year Treasury yield was at 4.19%, up from 4.25%. Bond yields move in the opposite direction.

“While European bonds are in decline, jumping, UK bonds are still a disaster,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I feel this morning may have been a capitulation for bonds in the short term. But we’ll see. Equity guys are obviously still very nervous and the dollar is still at an intraday high.”

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

Arone said there are other factors at play globally. “China has slowed economic growth through its Covid strategy and shared prosperity,” Arone said. “They have been slow to introduce easy monetary policy or additional fiscal spending.”

Arone said the common features around the world are economic slowdowns and high inflation, with central banks trying to contain high prices. Central banks are also raising interest rates while ending bond-buying programs.

Strategists say the U.S. central bank rattled markets in particular by predicting a new rate hike to a level where it believes it will stop hiking. The Fed’s forecast high water rate of 4.6% for next year is considered its “termination rate,” or floor rate. However, strategists still see it as flat until the path of inflation is clear, and fund futures for the start of next year raced above that level to 4.7% on Friday morning.

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

Monitoring for signs of market stress

Boockvar said that the market moves are painful because central banks have been releasing pre-pandemic money for years. He said global central banks had pushed down interest rates since the financial crisis and until recently rates were negative in Europe.

“All these central banks have been sitting on a beach ball in the pool for the last 10 years,” he said. “Now they get off the ball and it bounces pretty high. What happens is that emerging market currencies and debt trade like emerging markets.”

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he thinks markets will start pricing in a higher final rate for the central bank, up to 5%. “I would say the force was triggered by the Federal Reserve, which encouraged the market to reprice the closing rate. That was certainly one of the factors that triggered this volatility,” he said.

A higher closing rate should continue to support the dollar against other currencies.

“Despite our problems here in the U.S., with the Fed cutting GDP to 0.2% this year, stagnation still seems like a better bet than looking at the alternatives,” Chandler said.

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

“It’s like a 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 won’t know about them until the tide goes out and the rocks show up.”