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.
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.
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