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ECB stokes recession, debt fears; dollar rally cools but stocks struggle still

10 June 2022 Written by Raffi Boyadjian  XM Investment Analyst Raffi Boyadjian

The European Central Bank laid out a path to terminating all asset purchases and launching a series of rate hikes on Thursday as it sharply raised its inflation forecasts. But although the move was widely expected and the Bank flagged an initial rate increase of only 25 basis points in July, President Christine Lagarde left the door wide open for a 50-bps hike in September and beyond.

With no sign as of yet of a letup in the price surges across the euro area as Lagarde had been hoping, there now seems to be a sense of panic. The ECB is not just getting ready to raise interest rates a few times but is potentially about to enter a longer tightening cycle than many investors had envisioned it would.

ECB joins global inflation fight, roils markets

The hawkish turn sparked a renewed selloff in Eurozone sovereign bond yields. Periphery yields such as those of Italy and Spain spiked the most but German and French yields jumped substantially too. The ECB outlined plans to contain any fragmentation in the Eurozone bond market whereby it would be able to make flexible use of its PEPP reinvestments. Lagarde even assured that policymakers are ready to introduce new tools if necessary if fragmentation were to get out of hand.

But investors clearly wanted more details and a few alarm bells have been set off in the bond market amid some fears that highly indebted nations will struggle to meet their debt commitments if rates rise too high. The most telling part in all this, though, is the euro’s plunge yesterday even as yields soared. The single currency came close to breaching the $1.06 level as concerns about the ECB hiking into a slowdown overpowered any boost from the long-overdue shift towards policy normalization.

Stocks turn into a sea of red

The mood also soured in equity markets and European indices are on track to extend yesterday’s steep losses on Friday. The ECB waging war on inflation comes at a time when oil prices are moving back up towards the March peaks and the World Bank and OECD have just slashed their growth forecasts for the major economies.

With stagflation risks on the rise, stocks have been hammered this week as optimism is in short supply right now. Shares on Wall Street slumped on Thursday, led by the Nasdaq, which plummeted by 2.8%. Although long-dated Treasury yields have steadied a bit, the two-year yield is close to hitting a new 3½-year high as traders are no longer so sure that the Fed will pause its rate hikes later in the year.

The latest CPI numbers due out of the US later today could either reignite or dent hopes of the Fed going into lower gear. Analysts are expecting a print of 8.3% for May in the headline rate. There’s a danger that a stronger-than-expected figure could accelerate the selloff in equities.

Adding to today’s doom and gloom is the tightening of virus restrictions in China. Seven districts in Shanghai have been locked down so that health officials can carry out mass testing, while in Beijing, entertainment venues have been ordered to close. The latest curbs are weighing slightly on oil futures today but stocks in China have shrugged them off. A drop in Chinese producer prices in May has bolstered expectations of further loosening of monetary policy while strong foreign demand also helped local stocks to buck the global trend, with the CSI 300 index closing 1.5% higher.

A mixed picture in FX markets

The ongoing risk averse sentiment is keeping the US dollar at three-week highs against a basket of currencies. The greenback was the main winner on Thursday from the jitters about an economic downturn. But the euro is resisting further declines and the Australian and New Zealand dollars are recouping some of yesterday’s losses.

However, the Canadian dollar has slid past the C$1.27 level in spite of more hawkish language by the Bank of Canada in the last 24 hours. It’s possible that talk of the BoC’s next move being a 75-bps hike is adding to concerns about overtightening.

The Japanese yen, meanwhile, was mixed on Friday as intervention speculation continued to swirl in the markets. The safe-haven currency was unable to retain its gains against the dollar yesterday but at least in the short term, there seems to be a bit of resistance in the 134.50 yen area. Dollar/yen was slightly lower today to stand around 133.80 in European trading.

By XM.com



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