“I don’t expect changes of this magnitude to become commonplace,” Fed Chairman Jerome Powell said, speaking immediately after the central bank raised its base rate by 75 basis points (0.75%) to 1.5%-1.75%.
This is the third increase and the largest increase in short-term rates since 1994. This step was predictable and unexpected at the same time. A few weeks ago, Powell encouraged financial markets with the prospect of a half-point rate hike at the next monetary policy meeting. However, in the run-up to the meeting, investors quickly factored in the prices of more significant growth – and this is not the limit.
Powell’s comment about such a strong rise partially offset the sharp rise in bond yields in previous days and slowed the rise in stock prices. But no matter how hard he tries to sweeten the pill, the stakes are rising a lot more, and as a result, the likelihood of a hard landing for the economy has certainly increased. Now, many other than the Fed (for now) are expecting a recession. And the rapid shift in market sentiment shows that the Fed and other rich world central banks have lost control of what is happening.
The Fed’s interest rate decision comes after a series of unusual days in the financial markets, during which bond yields rose at an unprecedented rate, stocks fell, and riskier assets, notably bitcoin, as well as Italian government bonds, were crushed. The story doesn’t start in Washington or New York, but in Sydney, when the Reserve Bank of Australia (RBA) raised its base rate by 50 basis points on June 7, citing rising concerns about inflation. Amsterdam was next in line, where the European Central Bank (ECB) held a meeting on monetary policy, deciding to change the usual environment, as it usually meets in Frankfurt. Central bank chief Christine Lagarde confirmed that a 25 basis point hike in interest rates is possible in July. But she went even further. She said the ECB expects to raise interest rates by at least 50 basis points in September and “sustainable” increases thereafter. The tightening of the position is associated with a sharp upward revision of inflation forecasts by the Central Bank.
This triggered a sharp shift in the bond markets, and developments in other countries will give this an additional impetus. The yield on ten-year German government bonds, known as the bund, rose rapidly in the following days and topped 1.75%. Yields on riskier eurozone government bonds, notably Italy’s BTP, jumped even further. The spread between BTP and German bonds widened sharply, pushing the 10-year Italian bond yield to over 4%. Indeed, spreads have risen so rapidly that the ECB held an emergency meeting on June 15 to consider the matter.
Markets in a panic
However, it was the news from America that really shook the markets. Data released on June 10 showed inflation hit 8.6% in May, the highest since 1981. Underlying price pressure was unexpectedly strong. Worse still, according to a University of Michigan survey, consumer expectations for medium-term inflation have risen markedly. It seems that inflation has become more difficult to fight.
Treasury yields soared as the bond market began to factor in faster and faster Fed rate hikes. The strongest changes occurred in the short-term segment of the yield curve, which is most sensitive to changes in monetary policy. The two-year Treasury yield rose 57 basis points in just two trading days. However, long-term rates have also changed.
Stocks had almost no chance. The S&P 500 leading stock index fell 3% on June 10 and 4% the following Monday. These cumulative losses pushed stocks into bear market territory, which is defined as a drop of more than 20% from a recent peak. The high-tech NASDAQ index fell by more than 30% at the moment. Rising Treasury yields may have led stocks to crash, but supported the dollar. The Dxy Index, which measures the value of the dollar against half a dozen other rich world currencies, has gained 10% this year. This strengthening is especially noticeable against the yen, which hit a new 24-year low. While the Fed is tightening policy to bring inflation down, Japan’s central bank is actively buying bonds to boost inflation.
The recent volatility, especially in the bond market, seems to be quite extreme. How can this rage be explained? Despite the disappointing inflation data until last week, investors relished the thought that the worst was behind them. A survey of fund managers by Bank of America shows that investors have increased their holdings in bonds in recent weeks, possibly as bond prices have stopped falling. (Bond prices move inversely with bond yields.) In that case, the poor inflation performance caught them by surprise.
A market that moves strongly in one direction will often bounce back when the wind changes. And low liquidity exacerbates this effect. Regulatory changes have raised the cost of holding large stocks of bonds for banks found to trade with clients. The Fed, which used to be a reliable buyer of Treasuries, is winding down its buying program. When investors want to sell securities, there are too few people on the other side of the deal. Extreme market movements ahead of the Fed meeting added to the panic.
It can hardly be said that investors are bullish. A Bank of America survey found that fund managers’ optimism about the economic outlook is at an all-time low. Can a hard landing be avoided? Even Powell doesn’t sound too confident. It is worth getting ready for new troubles.
Prepared by Profinance.ru based on The Financial Times
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On this topic:
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The Fed’s plan to stave off a recession is on the brink of failure
Market crash evokes memories of the global financial crisis
The bond market storm has subsided a little, but the bears are still on the prowl.