In “fragile” financial markets ahead of the Fed’s decision, some traders and strategists see the risk of an immediate recession

Financial markets have been on a precarious footing since last Friday’s surprise data on accelerating US inflation for May – with Treasuries, equities, credit and currencies all showing friction or tension ahead of Wednesday’s Federal Reserve interest rate decision.

According to strategist Ben Emons and trader Tom di Galoma, the process of transmitting monetary policy through U.S. financial markets is currently stalled and risks spiraling higher inflation expectations and sending the world’s largest economy into an “immediate recession.” ” to drive. Even those who don’t see this as a base case, like strategist Marc Chandler, said that “the market may tighten faster than the Federal Reserve wants and faster than the underlying economy can handle.”

Financial conditions began to take a particularly sharp turn last Thursday, a day before Friday’s US CPI report showed an unexpected 8.6% year-on-year rise in US inflation. Since then they have continued to intensify. Now, with Fed policymakers expected to deliver a jumbo-sized 75 basis point hike in interest rates on Wednesday, Emons and di Galoma said whatever it takes to trigger another asset sell-off is a Fed ambiguity Chair Jerome Powell is excited about what the central bank will do in July, which would allow the financial market to extrapolate that more big rate hikes are imminent.

“If Powell is unclear about the next move for July, markets will respond with volatility,” New York-based Medley Global Advisors’ Emons said by phone on Tuesday. “We’re dealing with the worst combination of inflation imaginable and the Fed is not just behind the curve, it’s behind 10 corners.”

On Monday, the reverberations of the CPI report continued to rock financial markets, with tightening financial conditions accelerating and recession fears growing in the absence of other major market-moving news items. The spread between 2-year and 10-year Treasury yields shrank below zero, reversing in a sign of economic worries, while the S&P 500 index ended bearish and the Dow Industrials fell nearly 900 points. The ICE US Dollar Index DXY,
which measures the currency against a basket of six major rivals, rose 1% and traded near a near 20-year high.

“We can absolutely do that again tomorrow. The financial impact of currencies, bonds and stocks will send the economy into recession – no ifs or buts.”

— Bond trader Tom di Galoma

Volatility in financial markets “really increased” Thursday through Friday as people began to position themselves on the view that May’s CPI report would be worse than expected, Emons said. The pressure built over the weekend “until it reached extremes on Monday”. Emons sees the potential for higher inflation expectations leading to expectations for a higher fed funds rate, which will “accelerate the economy into contraction.”

A Article in the Wall Street Journal on the likelihood that the Fed will consider a 0.75 percentage point hike on Wednesday, released late Monday, was enough to “scratch” the Treasury market amid rapid and overwhelming selling flows, according to Emons. Liquidity on benchmark US Treasuries evaporated as bid-ask spreads widened and one major trader said the cost of trading bonds was rising rapidly as there was no anchor from the Fed or other central banks issuing bonds bought.

After the dust settled, traders and strategists awoke with clear eyes. In a note issued ahead of the market open Tuesday, Emons wrote that recession fears don’t necessarily translate into economic data and that financial markets could send the world’s largest economy into a downturn. “The Fed needs stable markets to implement its policies,” he wrote. “Right now, the transmission of monetary policy is being hampered everywhere. The risk is that market expectations will turn in the wrong direction and push the economy into an instant recession.”

“Markets are fragile because expectations are at an extremely bad point,” Emons wrote. A BofA survey “has boosted stagflation trading: long cash, US dollars, commodities, healthcare, resources, quality and value stocks, while short bonds, European and emerging market stocks, technology and consumer stocks.”

Bond trader Tom di Galoma of Seaport Global Holdings in Greenwich, Connecticut, underscored Emons’ view, saying in a telephone interview: “People have lost a tremendous amount of wealth here since the beginning of the year. It was a complete bloodbath.”

On Monday, the two-year Treasury yield TMUBMUSD02Y rose,
rose 23.2 basis points to hit its highest level since December 2007 amid one of the largest Treasury sell-offs since the bankruptcy of Lehman Brothers Holdings Inc. Volatility in the currency market reached levels not seen since the 1980s, it said di Galoma. And the front end of the Treasury market “had absolutely no liquidity, it was all sellers,” he said.

“We can absolutely do that again tomorrow,” said di Galoma. “The financial impact of currencies, bonds and stocks will send the economy into recession — no ifs, no buts.” The Wall Street Journal article was likely seen by policymakers as “putting a band-aid on the sell-off, but ambiguity in July would trigger a sell-off.”

Right now, Fed funds futures traders are pricing in a 96% chance of a 75 basis point hike on Wednesday and a 95% chance of a similarly sized move in July, the company said CME FedWatch tool. They see a 68% chance that the Fed will return to a 50 basis point hike in September – bringing the Fed funds’ target range from a current level of between 0.75% and 1% to 2.75% to 3% would.

As of Tuesday, the Dow Industrials DJIA,
and the S&P 500 SPX,
each closed lower for a fifth straight trading day – down 0.5% and 0.4% respectively – during the Nasdaq Composite COMP,
ended up 0.2% higher. Government bond yields rose, led by 3-month to 1-year rates. The spread between 2- and 10-year yields reversed earlier in the day, while the 5- and 30-year spread remained inverted – at minus 17 basis points.

Beyond stocks and bonds, rising volatility measures support the idea of ​​choppy credit and foreign exchange markets, said Chandler, chief market strategist at Bannockburn Global Forex. Still, he dismisses the notion of an “immediate recession,” saying downturns will take time to develop and much will depend on how well the job market and American consumers hold up. He notes that demand for gasoline, which recently reached a national average of $5 a gallon, has not been destroyed.

In addition, Chandler said, the Fed wants to see financial conditions tighten — and that’s what a higher dollar, rising interest rates and lower stock prices are doing. And policymakers can still telegraph where they see the Fed’s key interest rate target at the end of this year through Wednesday’s roundup of economic forecasts. But the central bank won’t want to unsettle markets any further, and a 50 basis point rate hike on Wednesday would be “more destabilizing”.

Powell has spoken in the past of trying to avoid uncertainty, though he’s also tried to remain agile on the interest rate path. Given the conditions and vulnerability of capital markets, “strategic ambiguity may not be good enough right now,” Chandler said over the phone.

“The notion that the market is about to go haywire — and the Fed needs to put stronger guardrails in place to keep it from going haywire — is a reasonable case that connects the facts,” Chandler said. “Failing to provide more solid guidance from the Fed, which means sacrificing some strategic ambiguity, means keeping markets choppy, which poses greater economic risks.” In “fragile” financial markets ahead of the Fed’s decision, some traders and strategists see the risk of an immediate recession

Brian Lowry

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