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Cumulative effects of monetary policy hit markets

The US Federal Reserve raised interest rates by 0.5 percentage points this week.

The European Central Bank and the US Federal Reserve delivered hawkish messages to the markets as they each raised interest rates 0.5 percentage points this week. The message was clear: financial conditions are not restrictive enough, and they need to become more restrictive to cool inflation. The longer it takes for markets to fall in line, the more hawkish this message is likely to become. 

European markets responded favourably to the ECB’s announcement, with bond yields popping higher in Germany and Italy. Meanwhile, US bonds are not responding at all. Despite the Fed indicating that overnight rates were likely to rise to 5.1% in 2023, Fed Funds futures have barely budged.

The Fed Funds futures curve has seen its rates rise by just six basis points (bps) to 4.5% since the close on 13 December. That places a shockingly wide gap of 60 bps between the December Fed Futures rate and the Fed target of 5.1%. It’s the equivalent of at least two rate hikes. 

German two-year rates

On the other hand, rates in Europe took no time at all to leap higher following the ECB meeting. The German two-year rate responded almost immediately, jumping higher during President Lagarde's more hawkish-than-expected message at the press conference. The two-year German bund rose by nearly 23 bps to 2.43%, and could head higher. It rose through resistance at 2.2%, while the relative strength index rose above a downtrend, suggesting a shift in momentum and the possibility that yields could rise. 

Dax nears support

Surging rates resulted in Germany’s Dax stock index falling by more than 3.3% on Thursday. More importantly, it dropped below a key support level of approximately 14,100. That is a significant breakdown because it raises the possibility that the entire rally since 10 November could be erased. The Dax also gapped below an uptrend that formed on 17 October, another bearish signal that could lead to a further decline below support at 13,700.

S&P 500 slides

US equity markets may only now be beginning to feel the cumulative effects of all the tightening that has taken place in 2022. The S&P 500 has dropped almost 4% since Wednesday’s Fed policy statement. The preceding rally in the S&P 500 was just a retest of a broken rising wedge pattern, suggesting that the index could revisit this year’s lows in the near future. 

Pound weakens

The British pound has weakened against the dollar and the euro since the Bank of England raised interest rates by 0.5 percentage points, partly because its announcement did not sound as hawkish as those of the Fed or the ECB. Additionally, the pound failed to sustain a break-out attempt versus the dollar, resulting in the pound falling below $1.22. It also pushed the pound back below an uptrend. Whether the breakdown in the pound versus the dollar continues could depend on how the market digests all the monetary policy changes this week. A further decline in the pound would suggest that the market believes the BoE is unlikely to be as aggressive as the Fed in future policy meetings. 

Cumulative effects weigh on markets

This week's general message from central banks is that rates need to go higher, and financial conditions are not restrictive enough. So, while some currencies may advance or fall, what seems clear is that interest rates will continue to rise, and equities are likely to struggle. 

Taking that one step further, the entire global equity market rally since the middle of October was based on the idea that central banks were stepping down the pace of tightening as they neared the end of their rate hiking cycles. That turned out to be wrong. Therefore, the stock market rally off the October lows could soon be erased across all markets.

Charts used with the permission of Bloomberg Finance LP. This report contains independent commentary to be used for informational and educational purposes only. Michael Kramer is a member and investment adviser representative with Mott Capital Management. Mr Kramer is not affiliated with this company and does not serve on the board of any related company that issued this stock. All opinions and analyses presented by Michael Kramer in this analysis or market report are solely Michael Kramer's views. Readers should not treat any opinion, viewpoint, or prediction expressed by Michael Kramer as a specific solicitation or recommendation to buy or sell a particular security or follow a particular strategy. Michael Kramer's analyses are based upon information and independent research that he considers reliable, but neither Michael Kramer nor Mott Capital Management guarantees its completeness or accuracy, and it should not be relied upon as such. Michael Kramer is not under any obligation to update or correct any information presented in his analyses. Mr. Kramer's statements, guidance, and opinions are subject to change without notice. Past performance is not indicative of future results. Past performance of an index is not an indication or guarantee of future results. It is not possible to invest directly in an index. Exposure to an asset class represented by an index may be available through investable instruments based on that index. Neither Michael Kramer nor Mott Capital Management guarantees any specific outcome or profit. You should know the real risk of loss in following any strategy or investment commentary presented in this analysis. Strategies or investments discussed may fluctuate in price or value. Investments or strategies mentioned in this analysis may not be suitable for you. This material does not consider your particular investment objectives, financial situation, or needs and is not intended as a recommendation appropriate for you. You must make an independent decision regarding investments or strategies in this analysis. Upon request, the advisor will provide a list of all recommendations made during the past 12 months. Before acting on information in this analysis, you should consider whether it is suitable for your circumstances and strongly consider seeking advice from your own financial or investment adviser to determine the suitability of any investment. Michael Kramer and Mott Capital received compensation for this article.

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