Financial markets are on precarious footing since last Friday’s surprise reading on accelerating U.S. inflation for May — with Treasurys, stocks, credit and currencies all exhibiting friction or tension ahead of the Federal Reserve’s rate decision on Wednesday.
According to strategist Ben Emons and trader Tom di Galoma, the process of transmitting monetary policy through U.S. financial markets is hamstrung right now and there’s a risk that higher-inflation expectations spiral and push the world’s largest economy into “an instant recession.” Even those who doesn’t see that as a base-case scenario, like strategist Marc Chandler, said the “market might be tightening faster than what the Federal Reserve wants and faster than what the underlying economy can cope with.”
Financial conditions began to take a particularly sharp turn last Thursday, a day before Friday’s consumer-price index report showed an unexpected 8.6% year-over-year gain in the headline U.S. inflation rate. They’ve continued to tighten ever since. Now with Fed policy makers seen as likely to deliver a jumbo-size 75-basis-point hike on Wednesday, Emons and di Galoma said all it would take to trigger further asset selloffs is ambiguity from Fed Chairman Jerome Powell on what the central bank will do in July, which would allow the financial market to extrapolate that further big hikes are on the way.
“If Powell is unclear about the next step for July, the markets will react with volatility,” Emons, based in New York, said via phone on Tuesday. “We are dealing with the worse inflation combination you could wish for and the Fed is not just behind curve, but behind 10 curves.”
On Monday, reverberations from the CPI report continued to rock financial markets, with the tightening of financial conditions accelerating and recession fears growing in the absence of any other major market-moving news. The spread between 2- and 10-year Treasury yields shrunk below zero and inverted in a sign of economic worry, while the S&P 500 finished in a bear market and Dow industrials dropped almost 900 points. The ICE U.S. dollar index
which measures the currency against a basket of six major rivals, jumped 1% to trade near an almost 20-year high.
““We absolutely can get a repeat of this tomorrow. The financial fallout in currencies, bonds and stocks is going to send the economy into a recession — no ifs, ands, or buts about it.””
— Bond trader Tom di Galoma
Financial-market tension “really took off” from Thursday into Friday, when people started to position on the view that May’s CPI report would be worse than thought, Emons said. Pressure built over the weekend “until it hit extremes on Monday.” Emons sees the potential for higher inflation expectations to lead to expectations for a higher fed funds rate, which will “accelerate into the economy going into a contraction.”
A Wall Street Journal article on the likelihood that the Fed will consider a 0.75-percentage point hike on Wednesday, released late Monday, was enough to cause the Treasury market to start “cratering” amid rapid and overwhelming selling flows, according to Emons. Liquidity on benchmark U.S. government bonds evaporated as bid/ask spreads widened and one major dealer described the cost of transacting bonds as rising fast, given the lack of an anchor from the Fed or other central banks buying bonds.
After the dust settled, traders and strategists woke up clear-eyed. In a note released before markets opened on Tuesday, Emons wrote that recession fears aren’t necessarily showing up in economic data and that financial markets are what might push the world’s largest economy into a downturn. “The Fed needs stable markets to carry out policy,” he wrote. “Right now, monetary policy transmission is hampered in all corners. The risk is that market expectations spiral in the wrong direction and push the economy in an instant recession.”
“Markets are fragile because expectations are at an extreme dire point,” Emons wrote. One BofA survey “has the stagflation trade put on in size: long cash, US dollar, commodities, healthcare, resources, high quality, and value stocks, while short bonds, European and emerging-market stocks, tech and consumer shares.”
Bond trader Tom di Galoma of Seaport Global Holdings in Greenwich, Conn., underscored Emons’ view, saying in a phone interview: “People have lost a tremendous amount of wealth here since the first of the year. It’s been a complete blood bath.”
On Monday, the two-year Treasury rate
rose 23.2 basis points, hitting its highest level since December 2007 amid one of the biggest selloffs of the government note since Lehman Brothers Holdings Inc. filed for bankruptcy. Volatility in the bills market reached levels that haven’t been seen since the 1980’s, di Galoma said. And the front end of the Treasury market “had absolutely no liquidity, it was all sellers,” he said.
“We absolutely can get a repeat of this tomorrow,” di Galoma said. “The financial fallout in currencies, bonds and stocks is going to send the economy into a recession — no ifs, ands, or buts about it.” The Wall Street Journal’s article was likely seen by policy makers as “putting a Band-Aid on the selloff, but ambiguity around July would trigger a selloff.”
For the moment, fed-funds futures traders are pricing in a 96% chance of a 75 basis point hike on Wednesday and 90% chance of a similar-size move in July, according to the CME FedWatch Tool. They see a 64% chance that the Fed will return to a 50- basis-point increment in September — which would take the fed funds target range to between 2.75% and 3%, from a current level between 0.75% and 1%.
As of Tuesday afternoon, Dow industrials
and the S&P 500
continued to sell off, while the Nasdaq Composite
moved higher. Treasury yields soared, led by the 2-year rate which is most closely tied to the Fed’s near-term policy path. The spread between 2- and 10-year rates inverted earlier in the day, while the 5- and 30-year spread remained inverted — at almost minus 15 basis points.
Beyond stocks and bonds, rising volatility measures support the idea of unsettled credit and currency markets, said Chandler, chief market strategist at Bannockburn Global Forex. Still, he pushes back on the notion of an “instant recession” — saying downturns take time to develop and much will still depend on how much the labor market and American consumer hold up, noting that there’s been no destruction of demand for gasoline which recently hit a national average of $5 a gallon.
In addition, Chandler said, the Fed wants to see tightening financial conditions — which is exactly what a higher dollar, rising rates, and lower stock prices are doing. And policy makers can still telegraph where they see the Fed’s main policy rate target heading at the end of this year through its Summary of Economic Projections on Wednesday. But the central bank will not want to unsettle markets further and a 50 basis point rate hike on Wednesday would be “more destabilizing.”
Powell has spoken in the past about striving to avoid uncertainty, though he’s also tried to be nimble on the path of interest rates. Given conditions and the vulnerability of capital markets, however, “strategic ambiguity is maybe not good enough right now,” Chandler said via phone.
“The idea that the market may be on the verge of coming unhinged — and the Fed has to give stronger guard rails to prevent it from coming unhinged — is a reasonable case that connects the facts,” Chandler said. “If the Fed does not give more solid guidance, which means sacrificing some strategic ambiguity, it means keeping markets unsettled, which has greater economic risks.”