Market downturn continues amid fears inflation may become a self-fulfilling prophecy

U.S. update

With record-high inflation and bearish economic signals across the board, the Fed’s goal of a soft landing could prove challenging. At the ECB Forum on Central Banking last Wednesday, Powell maintained the Fed’s aggressive rate hike policy, despite the risk of a potential recession, arguing that, “the bigger mistake to make — let’s put it that way — would be to fail to restore price stability.” One school of thought is that rising prices, and the fear of further rising prices, could actually change consumer behaviors and increase demand, thereby driving prices up. An alternate school of thought is that inflation will cool off demand, slowing economic growth and tempering prices over time. We may ultimately see both scenarios playing out in different pockets of the market. Similarly, many corporates are locking in interest rates now, for fear of rate increases that are more aggressive than current projections, while others are anticipating or hoping for a softer landing than the market is currently pricing in. Expectations of the Fed funds target rate by year-end now stand at 3.25 - 3.50%.

Despite Powell’s aspirations for a soft landing, the market continued its downturn. On Wednesday, real GDP was announced to have shrunk by 1.6% in Q1, marking the first of two consecutive negative quarters necessary to designate the economy as officially in recession. The ISM Manufacturing Purchasing Managers Index, an economic index representing U.S. manufacturing health, also took a larger hit than the market expected. The Institute for Supply Management announced on Friday that the index dropped from 56.1 in May to 53 in June, pointing to supply chain issues and lower demand. Equities were not spared either; since last Monday, the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite have fallen 3.46%, 2.84%, and 3.71% respectively. The end of the quarter solidified the worst first half for the S&P 500 since 1970, a roughly 21% decline. To top it all off, the consumer confidence index came in at a 16-month low of 98.7 on Tuesday, suggesting the market may be bracing for a potential recession.

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Update abroad

Globally, foreign central banks are somewhat moving in lockstep with the Fed’s hawkish monetary policy, albeit slowly. The ECB announced proceeds of the PEPP bonds that matured on Friday will be paid out to Italy, Spain, Portugal, and Greece in preparation for Eurozone rate hikes in July and September. These mark the first Eurozone interest rate hikes in 11 years. The ECB now faces a juggling act between hiking rates to combat high inflation and maintaining economic productivity across Europe. Alarmingly, this Friday, the Eurozone’s preliminary June consumer price index grew at a staggering 8.6% YoY, giving the ECB even more food for thought.

Foreign exchange markets reacted last Friday and this Tuesday to the recently announced Eurozone CPI news by flocking to the dollar. The EUR/USD exchange rate hit a 20-year low today, breaking through the resistance at 1.04 and dipping down to 1.0241. British Sterling, following a similar pattern, dipped to 1.1901 against the USD.

Looking ahead

This week, keep your eyes peeled for the ECB’s published account of their monetary policy meeting and ECB President Lagarde’s speech. Additionally, stay tuned for U.S. crude oil inventories, June nonfarm payroll, and June’s unemployment rate.