Financial markets have been in precarious shape since last Friday’s surprise reading of the acceleration in US inflation for May, with Treasury bonds, stocks, credit and currencies showing friction or tension ahead of Wednesday’s decision of the Federal Reserve on interest rates.
According to strategist Ben Emons and trader Tom di Galoma, the process of transmitting monetary policy through the US financial markets is currently stalled and there is a risk that higher inflation expectations will spiral out and push. the world’s largest economy in “an instant recession.” Even those who do not see it as a baseline, such as strategist Marc Chandler, said that “the market could be adjusting faster than the Federal Reserve wants and faster than the economy can handle. underlying “.
Financial conditions began to take a particularly sharp turn last Thursday, a day before the US Consumer Price Index report on Friday showed an unexpected 8.6% year-on-year rise in the general inflation rate of the USA. They have continued to tighten since then. Now that Fed policymakers are likely to offer a 75-point increase in the Fed’s rate of funds on Wednesday, Emons and Di Galoma said all that would be needed to provoke a new sale of assets is the Fed Chairman Jerome Powell’s Ambiguity on what the central bank will do in July, which would allow the financial market to extrapolate that there are new interest rate hikes.
“If Powell isn’t clear on the next step for July, markets will react volatilically,” New York-based Medley Global Advisors’ Emons said Tuesday. “We are dealing with the worst combination of inflation you could wish for and the Fed is not only behind the curve, but behind the curves of 10.”
On Monday, the repercussions of the CPI report continued to shake financial markets, with accelerating tightening financial conditions and fears of a growing recession in the absence of any other major market news. The gap between 2- and 10-year Treasury yields fell below zero and was reversed as a sign of economic concern, while the S&P 500 index ended in a bearish market and Dow industrialists fell nearly 900 points. The ICE DXY US Dollar Index
which measures the currency against a basket of six major rivals, rose 1% to trade near a high of nearly 20 years.
““Tomorrow we can say it all over again. The financial consequences of currencies, bonds and stocks will send the economy into a recession: there is no yes, and no but.”
Financial market volatility “really disappeared” from Thursday to Friday, when people began to take a stand on the view that May’s CPI report would be worse than previously thought, Emons said. Pressure rose over the weekend “until Monday reached extremes.” Emons sees higher inflation expectations as leading to expectations of a higher rate of fed funds, which “will accelerate the economy by shrinking.”
According to Emons, a Wall Street Journal article on the Fed’s chances of a 0.75 percentage point rise on Wednesday, published Monday afternoon, was enough to make the Treasury market begin to “hedge” in the middle. of fast and overwhelming sales flows. The liquidity of the benchmark U.S. government bonds evaporated as buying / selling spreads widened, and a major trader described the cost of bond transactions rising rapidly, given the lack of a Fed or other central banks that buy bonds.
After the dust settled, traders and strategists woke up with clear eyes. In a note released before the markets opened on Tuesday, Emons wrote that fears of recession do not necessarily appear in economic data and that financial markets are the ones that can push the world’s largest economy into a recession. “The Fed needs stable markets to carry out the policy,” he wrote. “Right now, the transmission of monetary policy is hampered in every corner. The risk is that market expectations will go in the wrong direction and push the economy into an instant recession. “
“Markets are fragile because expectations are at an extreme point,” Emons wrote. A BofA survey “shows the size of the stagnant trade: long cash, US dollar, commodities, health, resources, high quality and value stocks, while short bonds, European and emerging market stocks, stocks of technology and consumption “.
Bond trader Tom di Galoma of Seaport Global Holdings in Greenwich, Connecticut, underlined Emons’ opinion, saying in a telephone interview: “People have lost a huge amount of wealth here since the first year. bath full of blood “.
On Monday, the two-year Treasury yield TMUBMUSD02Y,
rose 23.2 basis points to its highest level since December 2007 amid one of the highest government note sales since Lehman Brothers Holdings Inc. declared bankruptcy. Banknote volatility reached levels not seen since the 1980s, Galoma said. And the front end of the Treasury market “had absolutely no liquidity, they were all sellers,” he said.
“Tomorrow we can absolutely repeat it,” Di Galoma said. “The financial consequences of currencies, bonds and stocks will send the economy into a recession, there is no yes, and no but.” The Wall Street Journal article was probably seen by policymakers as “putting a band-aid on sale, but the ambiguity around July would trigger a sale.”
For now, federal fund futures traders have a 96% chance of a 75 basis point increase on Wednesday and a 95% chance of a move similar in size to July, according to the CME FedWatch tool. They see a 68% chance that the Fed will return to a 50 basis point increase in September, which would bring the target range of federal funds between 2.75% and 3%, from a current level of 0, 75% and 1%.
Starting Tuesday, the Dow Industrial DJIA,
and the S&P 500 SPX,
each ended lower for a fifth consecutive trading day, 0.5% and 0.4%, respectively, while the Nasdaq Composite COMP,
finished 0.2% higher. Treasury yields soared, led by rates from 3 months to 1 year. The 2- to 10-year yield spread was reversed earlier in the day, while the 5- to 30-year spread remained reversed at less than 17 basis points.
Beyond stocks and bonds, rising volatility measures support the idea of unresolved credit and foreign exchange markets, said Chandler, chief market strategist at Bannockburn Global Forex. However, he rejects the notion of an “instantaneous recession”, saying that recessions take time to develop and that much will still depend on how the US market and consumer endure. He points out that there has been no destruction of gasoline demand, which recently reached a national average of $ 5 a gallon.
Also, Chandler said, the Fed wants to see a tightening of financial conditions, which is exactly what is making a higher dollar, rising interest rates and lower stock prices. And policymakers can still telegraph where they see that the main focus of the Fed’s policy rate is aimed at the end of this year through Wednesday’s Summary of Economic Projections. But the central bank will no longer want to worry the markets and a 50 basis point rate hike on Wednesday would be “more destabilizing.”
Powell has spoken in the past about the effort to avoid uncertainty, though he has also tried to be agile in the path of interest rates. Given the conditions and vulnerability of capital markets, however, “strategic ambiguity may not be good enough right now,” Chandler said by telephone.
“The idea that the market may be about to take off, and the Fed needs to provide stronger guardrails to prevent it from taking off, is a reasonable case that connects the facts,” Chandler said. “If the Fed does not give a stronger direction, which means sacrificing some strategic ambiguity, it means keeping markets volatile, which leads to more economic risks.”