The financial markets are nothing less than historically exciting at the moment. The primary driving force of which, is the world’s most powerful central bank, the Federal Reserve Bank (Fed) in the USA. On July 27th, investors experienced another very significant increase in interest rates of 0.75 percentage points. Graph one shows how historic the current course is, and even for the Fed, a monetary policy tightening of this caliber is unchartered territory, so market alertness is kept at top level for a good reason.
In January, virtually all investors were caught off-guard when it became apparent that the Fed would raise interest rates seven times this year. At that time however, the belief was still that the US central bank would use the standard steps of 0.25 percentage points per hike. If I remember correctly, I noted in April that it appears that the US central bank rate, Fed Funds, could reach 3.00 pct. at the end of the year. After the last interest rate increase, the interest rate is now already at 2.50 pct. and 3.00 pct. will soon become a reality.
Many central banks have fallen behind in raising interest rates, which again explains the aggressive moves from the Fed. Though there is more in it than just being behind, throughout the first half of the year, the Fed itself has recognized the need for very drastic steps concerning the interest rate increases. The usual cautious behavior with gradual impacts on the economy has been abandoned by the Fed this time. It has been concluded that part of the inflation is precisely due to low output in the economy, and therefore, the Fed will provoke a demand shock. They simply want to smash some economic china to force a slowdown in growth.
Normally, a central bank will not act like “a bull in a china shop” but right now, a new kind of “bull” has been unleashed on Wall Street. It is one that must destroy demand in the economy, and not symbolize a positive market and rising prices as a “bull market” normally does.
Throughout the second quarter, the Fed became clearer in its rhetoric, also in terms of provoking a slowdown in demand. It was one of several reasons behind the steep drops that characterized the financial markets during the second quarter. At the same time, this means that the current sharp interest rate increases are expected and are already largely factored in the prices – maybe.
I will admit that I found the lead-up to the Fed’s interest rate hike quite interesting, almost too interesting perhaps. In Europe, gas prices rose by a further 25 pct. in one day, the German IFO index fell further, American supermarket chain Walmart warned of falling profits, and Meta/Facebook also had to disappoint investors.
So far, the financial markets have pulled through all the lurking dangers, and Wall Street is not particularly intimidated by the new bull. Right now, the stock market is most focused on Fed chairman Jerome Powell’s remark that the speed of interest rate increases may slow down. One day it of course will happen, and based on interest rate contracts that are traded, the expectation right now is that the Fed will already lower interest rates in 2023, while the Fed itself is forecasting 2024.
Maybe Wall Street is a little too optimistic these days, but my main conclusion based on the days surrounding the latest US interest rate hike is that the financial market has regained some resilience, which is very positive. August is not over yet, and it is a big summer holiday month where anything can happen, but so far, the development is good.
I have long regarded the sell-off in the financial markets during the first half of the year as a correction, admittedly a very large one, but a correction means that the sell-off finds a bottom, which is quite different from a big panic sell-off. In my view, the price development this summer confirms the assessment that the sell-off is a correction.
My major concern remains with the European stock market, which I believe is importing too much optimism from Wall Street. More people begin to take notice on how the European Central Bank (ECB) has failed in terms of conducting monetary policy, though in Europe, a fall in demand and a contractionary macroeconomic development is emerging “naturally” and without help from the ECB.
On July 28th, it once again became clear how the economic barometer stands. The EU Commission publishes a so-called ESI index, which is shown in graph two, and it turned out much worse than expected for the month of July. It declined in all economic segments, except for inflation expectations, which rose. The index represents expectations, but I have no doubt about what awaits the European economy and investors. It is a structural economic downward move, which is quite different compared with the china that the Fed wants to break. This summer’s development also confirms to me that investors should continue to underweight investment allocations to the Eurozone, an assessment that I have not changed for a long time.