Stocks fell sharply, bond yields rose and the dollar strengthened on Friday as investors heeded the Federal Reserve’s signal that its battle with inflation could lead to much higher interest rates and a recession.
Friday’s selloff was global, in a week the Fed hiked rates another three-quarters point and other central banks raised their own interest rates to combat global trends in the inflation.
The S&P 500 closed 1.7% lower at 3,693 on Friday, after temporarily dipping to 3,647, below its June closing low of 3,666. The Dow Jones Industrial Average ended the rocky session of Friday at 29,890, a loss of 486 points and a new low for the year.
European markets fell further, with Britain’s FTSE and Germany’s DAX both closing around 2% and France’s CAC 2.3%.
Weak PMI data on manufacturing and services in Europe on Friday, and the Bank of England’s warning on Thursday that the country was already in recession added to the negative spiral. The British government also shook markets on Friday with the announcement of a plan of tax cuts and investment incentives to help its economy.
The Fed ‘endorses’ a recession
Stocks took on an even more negative tone earlier this week after the Fed raised interest rates by three-quarters of a point on Wednesday and forecast it could raise its key rate to 4.6% at the start of the month. ‘next year. This rate is now 3% to 3.25%.
“Inflation and rising rates are not an American phenomenon. It has also been a challenge for global markets,” said Michael Arone, chief investment strategist at State Street Global Advisors. “It is clear that the economy is slowing down, but inflation is soaring and the central bank is forced to deal with it. Pivot to Europe, ECB [European Central Bank] turns negative rates into something positive at a time when they have an energy crisis and a war in their backyard.”
The Fed also forecast that unemployment could climb to 4.4% next year, from 3.7%. Fed Chairman Jerome Powell strongly warned that the Fed would do what it had to do to crush inflation.
“By basically endorsing 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 see and you will continue to see it in the short term in the blind selling of virtually all assets. The good news is that this tends to be the end game of virtually all bear markets that we have. never seen, and it happens in September and October, where it has always been the normal situation.”
Recession concerns also dragged the commodity complex lower, with metals and agricultural commodities all selling across the board. West Texas Intermediate oil futures fell about 6% to just above $78 a barrel, the lowest price since early January.
Europe, book impact
As the US stock market opened, Treasury yields moved away from their highs and other sovereign yields also fell. The British government’s announcement of a sweeping tax cut plan added to that country’s debt turbulence and hit the pound hard. The British 2-year Gilt yielded 3.95%, a rate which was at 1.71% at the beginning of August. The 2-year US Treasury note was at 4.19%, after peaking above 4.25%. Bond yields move opposite to prices.
“European bonds, although down, are rebounding, but UK gilts are still a disaster,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “I feel like this morning could have been, in the short term, a bond sell-off. But we’ll see. Equity players are obviously still very nervous and the dollar is still at the high of the day.”
The dollar index, largely influenced by the euro, hit a new 20-year high and rose 1.4% to 112.96, while the euro fell to $0.9696 to the dollar .
Arone said other factors are also at play globally. “China, through its Covid strategy and common prosperity, has slowed economic growth,” Arone said. “They’ve been slow to introduce accommodative monetary policy or additional fiscal spending at this point.”
Arone said the common threads around the world are slowing economies and high inflation, with central banks pledging to rein in high prices. Central banks are also raising rates as they end bond-buying programs.
Strategists say the U.S. central bank particularly rattled markets by forecasting a new forecast of higher interest rates, for the level where it thinks it will stop rising. The high water rate of 4.6% forecast by the Fed for next year is considered its “terminal rate,” or final rate. Yet strategists still see it as fluid until the course of inflation is clear, and fed funds futures for early next year have topped that level, at 4.7% Friday morning.
“Until we get a picture where interest rates go down and inflation starts going 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.”
Watch for signs of market stress
Boockvar said market moves are painful as central banks roll out years of easy money, even before the pandemic. He said interest rates had been suppressed by global central banks since the financial crisis and until recently rates in Europe were negative.
“All of these central banks have been sitting on a beach ball in a swimming pool for the past 10 years,” he said. “Now they’re going away and it’s going to bounce quite high. What’s happening is developing market currencies and debt are trading like emerging markets.”
Marc Chandler, chief market strategist at Bannockburn Global Forex, said he thought markets were starting to price in a higher terminal rate for the Fed, up to 5%. “I would say the forces were unleashed by the Fed, encouraging the market to revalue the terminal rate. That’s definitely one of the factors that triggered this volatility,” he said.
A higher terminal rate should continue to support the dollar against other currencies.
“At the end of the day, despite our problems here in the United States, with the Fed revising GDP down this year to 0.2%, stagnation, we still seem like the best bet when you look at the alternatives,” said Chandler.
Strategists said they saw no specific signs but were watching markets for any signs of stress, particularly in Europe where rate moves have been dramatic.
“It’s like the Warren Buffett quote. When the tide goes out, you see who’s not wearing a bathing suit,” Chandler said. “There are places that have enjoyed low fares for a long time. You don’t know them until the tide goes out and the rocks appear.”