The financial markets remain very volatile as they are shaken by the double force of the slowdown in global activity and the continued rise in inflationary pressures. Significant intraday moves in equity and bond markets are on the cards, amid considerable uncertainty about the economic outlook, as well as the extent of monetary tightening by central banks.
Significant rate hikes are expected for the coming quarter, with the European Central Bank and the US Federal Reserve likely to raise rates by at least 75 basis points, or 0.75%, and 125 basis points , or 1.25%, respectively, by September.
Further tightening is expected beyond that, but markets don’t know what rate spikes will be in different economies.
However, rates are not expected to peak in the Eurozone until late next year, much later than in the US or the UK.
We have seen a considerable amount of data released in recent weeks, indicating a slowdown in consumer spending, housing activity and industrial production in many countries.
The purchasing managers’ indices for June in the main advanced economies show a significant slowdown in both industry and services.
Thus, fears of a recession are growing.
As a result, market rate hike expectations have been revised down significantly over the past two weeks. In the United States, the federal funds rate is now expected to reach 3.25% at the end of this year, down from the peak of 4% set a fortnight ago.
In addition, US rates are then expected to be cut by 50 basis points, or 0.5%, in the second half of 2023.
Meanwhile, in the euro zone, rates are now expected to climb to 0.75% by the end of the year, from 1.25% previously, peaking at 1.5% towards the end of 2023. That’s down from the nearly 2.5% peak seen just a few weeks ago.
The recent easing of rate hike expectations is translating into sharp declines in long-term interest rates.
In the meantime, stock markets remain volatile, but are trying to bottom out after a very weak start to the year.
They welcome the idea that the slowdown in growth could reduce the extent of monetary policy tightening. Central bankers have changed their minds very quickly on policy this year as they face an inflationary shock. Policy decisions are now largely driven by the latest inflation data in particular.
It remains unclear how much global economic activity will slow in the second half of this year and into 2023, or how sustained the rise in inflation will be. Inflation, however, tends to lag the business cycle, especially when largely fueled by long-lasting supply-side shocks.
Central banks have stressed that their top priority is to bring inflation down from its current very high levels and restore price stability.
They will want to see clear evidence of significant progress in reducing inflation, before changing their minds on monetary policy.
A marked deceleration in inflation could take some time, however, especially if further supply disruptions hit global energy markets this winter. Thus, central banks may well retain a hawkish policy bias even as economic data continues to weaken and recession risks increase.
Overall, the markets are expected to remain very volatile for some time to come.