Markets in disarray as traders scramble to price in Fed warpath
S&P 500 enters bear market, crypto implodes, dollar powers up
Despite all the panic, there’s also some encouraging news
Bear market blues
All hell has broken loose in financial markets. Another scorching hot US inflation report shattered hopes that the Fed might be able to take its foot off the brakes later this year, sending traders scrambling to recalibrate the trajectory for interest rates and wreaking havoc in every asset class.
Market pricing has adjusted at a furious pace. Fed funds futures contracts imply a 95% probability for a 75 basis points rate increase this week and similar dynamics for July, amid intensifying speculation that the central bank will throw its own forward guidance to the wind and crank up borrowing costs at lightning speed.
The impact has been devastating. Stock markets fell off a cliff with the S&P 500 losing almost 4% yesterday to officially enter a bear market, US bond yields went through the roof to hit new decade highs, while junk bonds got nuked alongside cryptocurrencies. Even gold couldn’t escape the market’s wrath, with the yellow metal getting hammered lower as real yields went into overdrive.
The US dollar has been the sole survivor in the FX arena, drawing power from widening interest rate differentials as the Fed is expected to outgun other central banks and from its status as the world’s reserve currency that allows it to attract defensive capital flows. The greenback remains the ultimate ‘all purpose’ currency, offering both attractive yields and an aura of safety.
In contrast, every other major liquid currency is feeling the blues. The euro is suffering at the hands of soaring energy prices, the yen has been decimated by the Bank of Japan’s refusal to tighten policy, while the British pound and the commodity-linked currencies are trading in lockstep with unstable stock markets.
It is quite striking that oil prices have not taken one step back this week despite all the mayhem and whispers of a recession growing louder. This is a testament to the scarcity of oil barrels, which continues to intensify after Libya announced it has shut down almost all its oil fields and is producing virtually nothing amid another round of violence in the country’s long-running power struggle.
All told, it’s difficult being optimistic these days. Between the cost of living crisis squeezing consumers, the housing market feeling the burn of soaring mortgage rates, corporations warning of worker layoffs to control costs, and the Fed about to unsheathe an even sharper blade to slay inflation, it is only natural for markets to panic.
But there are a couple of reasons to be optimistic when everyone else is pessimistic. The Fed has historically reversed course at the first sign of trouble while the leaders of Germany, France, and Italy are planning to visit Ukraine this month in an attempt to broker peace.
The Fed wants to control inflation but willingly sparking a severe recession is not part of the game plan. It is more likely to accept a period of high inflation rather than push the US economy into a real crisis. And any concrete signs of de-escalation in Ukraine could drag energy prices lower, cooling inflation expectations and lessening the need for aggressive rate increases.
Keep a close eye on the S&P 500. The chart is a horror show right now but the bear market could begin to run out of steam as we approach the 3,500 region, a technical fortress that encompasses the 200-week moving average and the 50% Fibonacci retracement of the rally from the pandemic lows until record highs.