FED POURS COLD WATER ON MARKETS

The long-awaited Jackson Hole Symposium event recently spooked markets, which summarily handed back part of their summer gains just as the Fed shot down any prospect that it will go easy in its rate-raising cycle. Markets are now pricing in a 0.75-percentage point increase in September.

In a speech lasting only 10 minutes (instead of the usual half hour), the Fed chairman voiced his determination to combat inflation even if this means endangering economic growth. Quoting former Fed chairs Paul Volcker and Alan Greenspan, Powell recalled that a central bank’s duty was to ensure price stability. Hence a restrictive long-term monetary policy and consequently a period of low growth – complete with a weaker labour market – are now needed. He forewarned of “some pain” ahead.

Since the release of July’s inflation figures, which took a hiatus from their uptrend, markets had started anticipating more moderate behavior from the Fed. This prospect is what led risk assets higher recently. However, Powell’s words put paid to such hopes. The reaction by markets was not long in coming, as no less than USD 1.25 trillion in market capitalisation went up in smoke – marking the largest daily decline since June. The S&P 500 gave up 3.4% while the tech-heavy Nasdaq, more sensitive to rate expectations, dropped by 3.94% (almost 500 points).

In bond markets, the reaction was much softer. Yields have continued increasing on higher interest rate expectations. The 10-year Treasury has risen more than 8 points to 3.1% but remains below its mid-June peak. Two-year paper is at 3.4%. The yield curve remains visibly inverted with a spread of 36 basis points between the two maturities.

In Europe, the outlook is slightly gloomier, with the energy crisis weighing heavily on the economic recovery. Several members of the ECB recently set out arguments for a steep rise in rates at the September meeting. Despite the hawkish noises, with some favoring 0.75%, the ECB must tread cautiously. Given the fragile state of the European economy, a 0.5% hike seems more realistic.

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