The eight days that shook the markets

New York Stock Exchange (Reuters)
New York Stock Exchange (Reuters)

“I don’t expect moves of this magnitude to be common,” Federal Reserve Chairman Jerome Powell said on June 15. The central bank had just raised its benchmark interest rate by 75 basis points (0.75 percentage points), to 1.5%-1.75%. It was the third hike in as many meetings and the biggest jump in short-term rates since 1994. The move was as expected as it was surprising. Powell had warmed markets weeks ago with the prospect of a 50 basis point hike at this policy meeting. But in the days before, investors had quickly and fully priced in a bigger hike, and even more.

Powell’s comment about unusually large increases was enough to cause a partial reversal of the sharp rise in bond yields in the previous days and a recovery in stock prices. But As much as I tried to sugarcoat the message, rates are going to go much higher and the chances of a hard landing for the economy have certainly increased as a result. The recession is now more expectedif not (yet) by the Fed. And the rapid changes in market sentiment show the extent to which the Fed and other central banks in the rich world have lost control of events.

The Fed’s decision on interest rates came at the end of an extraordinary few days in financial markets, in which bond yields soared at a violent pace, stock prices slumped and assets in riskier, particularly bitcoin, but also Italian government bonds, sank. The story begins not in Washington or New York, but in Sydney, where on June 7 the Reserve Bank of Australia raised its benchmark interest rate by 50 basis points, citing growing concerns about inflation. The story continued in Amsterdam, where in the following days the European Central Bank (ECB) held its monetary policy meeting, breaking with its usual scene in Frankfurt.. Christine Lagarde, the head of the central bank, confirmed that a rate hike of 25 basis points will take place in July. But it went much further. The ECB, she said, expects to raise interest rates by perhaps 50 basis points in September and anticipates “sustained” rises thereafter. The catalyst for this more aggressive stance was a sharp upward revision of the central bank’s inflation forecasts..

A trader works on the floor of the New York Stock Exchange (NYSE) in New York City, US June 14, 2022. REUTERS/Brendan McDermid
A trader works on the floor of the New York Stock Exchange (NYSE) in New York City, US June 14, 2022. REUTERS/Brendan McDermid

This set the stage for a dramatic shift in the bond markets, to which events elsewhere added impetus. The yield on German 10-year government bonds, known as bunds, rose rapidly to over 1.75% in the following days. Yields on riskier eurozone government bonds, especially Italian btps, rose further. The spread (excess yield) of btps over bunds widened sharply, taking Italy’s 10-year yield above 4%. In fact, spreads rose so rapidly that the ECB’s rate-setting council held an emergency meeting on June 15 to discuss the matter.

But it was the US news that really moved the markets. Figures released on Friday June 10 showed that annual consumer price inflation rose to 8.6% in May, the highest rate since 1981. Underlying (“core”) price pressures were unexpectedly strong. As if that were not enough, a survey by the University of Michigan showed that consumer expectations about inflation in the medium term had increased markedly. Taken together, the reports suggested that inflation would be much more difficult to reduce.

Treasury yields rose sharply as the bond market began to anticipate more and faster interest rate hikes by the Federal Reserve. The biggest moves occurred at the short end of the yield curve, which is the most sensitive to changes in monetary policy. Two-year Treasury yields rose 57 basis points in the space of just two trading days. But longer-term rates also changed (see chart 1).

Figure 1
Figure 1

Stocks could not escape this adjustment (see figure 2). The s&p 500 index of major stocks fell 3% on June 10 and 4% the following Monday. The accumulated losses pushed the stock market into bear market territory, defined as a drop of more than 20% from its recent peak. The technology-heavy Nasdaq index has fallen further. Rising Treasury yields have weighed on stock prices, but have been a boost for the dollar. The dxy, an index of the greenback against half a dozen rich-world currencies, is up 10% this year. The strength is especially marked against the yen, which has fallen to a new 24-year low. As the Federal Reserve tightens its policy to reduce inflation, Japan’s central bank furiously buys bonds to raise it.

Graph 2
Graph 2

The recent volatility, especially in the bond market, has been quite extreme. What can explain this? As bad as the inflation picture seemed before last week, investors had taken comfort in the thought that the worst was over. Bank of America’s global survey of fund managers suggests that investors have increased their allocation to bonds in recent weeks, perhaps thinking that bond prices have stopped falling. (Bond prices move inversely to yields.) If so, the poor inflation numbers surprised them.

A market that is leaning strongly in one direction will often reverse when the wind changes. And the lack of liquidity amplifies the effect. Changes in regulation have made it more expensive for banks to hold large inventories of bonds to facilitate trading with clients. The Federal Reserve, once a reliable buyer of Treasuries, is cutting back on its purchases. When investors want to sell, there are very few willing to accept the other part of the operation. Violent market moves in the days leading up to the Fed meeting may have exaggerated the sense of panic.

However, it is difficult to argue that investors are bullish. The Bank of America survey shows that fund managers’ optimism about the economic outlook is at an all-time low. Can a forced landing be avoided? Even Powell seemed unconvinced. Prepare for more trouble.

© The Economist 2022. All rights reserved

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