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

Trader on the floor of the NYSE, June 7, 2022.

Source: NYSE

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

The sell-off was global on Friday, in a week in which the Fed raised interest rates by another three-quarters of a point and other central banks raised their own interest rates to counter global inflationary trends.

The S&P 500 was down more than 2% Friday morning at 3,675, with strategists saying it’s looking to test June’s close of 3,666. The Dow Jones Industrial Average approached a new low for 2022 on Friday.

European markets fell more, with the British FTSE and German DAX both falling about 2% and the French CAC 2.2%.

Weak PMI data on manufacturing and services out of Europe on Friday, and the Bank of England’s warning Thursday that the country was already in recession, added to the negative spiral. The UK government also shook markets on Friday, announcing a plan for sweeping tax cuts and investment incentives to help the economy.

Fed approves recession

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

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

The Fed also predicted that unemployment could rise to 4.4% from 3.7% next year. Fed Chair Jerome Powell steadfastly warned that the Fed will do what it needs to do to crush inflation.

“By essentially endorsing the idea of ​​a recession, Powell has kicked off the emotional phase of the bear market,” said Julian Emanuel, head of equities, derivatives and quantitative strategy at Evercore ISI. “The bad news is you see it and you will continue to see it in the near term in random selling of just about any asset. September and October, where historically that has been the normal course of business.”

Recession concerns also pushed the commodity complex down, with metals and agricultural commodities sold across the board. West Texas intermediate oil futures fell about 6% to just above $78 a barrel, the lowest price since early January.

Europe, Pound impact

When the US stock market opened, yields on government bonds were no longer so high and yields on other government bonds also fell. The British government’s announcement of a sweeping tax cut plan sparked a turmoil in that country’s debt and hit the British pound hard. The 2-year British Gilt yielded 3.95%, a yield that stood at 1.71% at the beginning of August. The US 2-year Treasury stood at 4.19%, at a high of over 4.25%. Bond yields move opposite to the price.

“European bonds are rising while they are falling, but UK government bonds are still a disaster,” said Peter Boockvar, Chief Investment Officer at Bleakley Advisory Group. “I feel like this morning would have been a short-term capitulation of bonds. But we’ll see. Stock people are clearly still very nervous and the dollar is still at the high of the day.”

The dollar index, largely influenced by the euro, reached a new all-time high in 20 years, rising 1.2% to 112.71, while the euro fell to $0.9721 per dollar.

Arone said there are other factors at play globally as well. “China has curbed economic growth through their Covid strategy and common prosperity,” Arone said. “They’ve been slow to put in place easy monetary policy or extra budget spending right now.”

Around the world, Arone said the common thread is slowing economies and high inflation, with central banks working to curb high prices. Central banks are also raising interest rates as they end bond buying programs.

Strategists say the US central bank has mostly confused the markets by predicting a new forecast of higher interest rates before the level it thinks it will stop walking. The Fed’s projected high-water rate of 4.6% for next year is considered its “final rate,” or closing rate. Still, strategists see that as fluid until inflation is clear, and futures on fed funds for early next year rose above that level, to 4.7% Friday morning.

“Until we get a picture where interest rates are falling and inflation starts to fall, we expect more volatility going forward,” Arone said. “The fact that the Fed doesn’t know where they will end up is an inconvenient place for investors.”

Watch out for signs of market stress

Boockvar said the market moves are painful as central banks unwind years of easy money, even pre-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 these central banks have been sitting on a beach ball in a pool for the past ten years,” he said. “Now they’re coming off the ball and it’s going to bounce pretty high. What’s happening is emerging markets currencies and debt are being traded as emerging markets.”

Marc Chandler, chief market strategist at Bannockburn Global Forex, said he thinks markets are starting to price in higher Fed interest rates, as high as 5%. “I would say the forces were unleashed by the Fed encouraging the market to reprice final interest rates. That was definitely one of the factors driving this volatility,” he said.

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

“The bottom line is that despite our problems here in the US, the Fed cut GDP to 0.2% this year, the stagnation, we still look better when you look at the alternatives,” Chandler said.

Strategists said they see no specific signs, but they are watching the markets for signs of stress, particularly in Europe where price movements have been dramatic.

“This is like the Warren Buffett quote. When the tide goes out, you see who isn’t wearing a swimsuit,” Chandler said. “There are places that have benefited from low rates for a long time. You don’t know until the tide goes down and the rocks appear.”

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