Market volatility to add additional pressure on Fed to ease

In a year that’s seen central banks weighing the risk of inflation staying too high against the chance of tipping economies into recession, policymakers now have a fresh dynamic to consider: volatile financial markets.

Initial reactions around the world to the mass selloff in equities on Monday showed that officials were hardly getting spooked.

Australia’s central bank Tuesday kept interest rates at a 12-year high and rejected the idea of cuts in coming months. Federal Reserve Bank of San Francisco President Mary Daly late Monday only indicated rate reductions would come in “coming quarters,” and noted that markets can move excessively in one direction. Japan’s central bank, Finance Ministry and financial regulator met Tuesday to discuss markets, concluding that there was no change in the view that the Japanese economy is recovering.

Equities mounted a rebound Tuesday from Tokyo to New York, though some investors cautioned against concluding the turmoil is done. Brown Brothers Harriman global strategists said that until more definitive data shows the US isn’t sliding into a recession, “expect heightened volatility across all markets as fear dominates.”

That suggests tighter financial conditions will add a fresh brake on growth. Falling inflation rates already meant that the real bite from high central bank rate settings was getting bigger. The volatility in markets now may argue for bigger or more frequent policy moves by year-end.

“The news flow still suggests a soft landing is possible,” said James Knightley, chief international economist at ING Financial Markets. “But in order to achieve it central banks — not just the Fed — will need to bring policy rates to a more neutral footing more quickly than they had previously been suggesting.”

Among the triggers for the plunge in equities was a weaker than expected US jobs report for July that fed the narrative that Chair Jerome Powell and his colleagues had erred in failing to lower rates already at their July 30-31 meeting. Next Thursday’s retail sales report for July may help to stabilize sentiment, Brown Brothers global strategists led by Win Thin wrote in a note Tuesday.

Broader data show little worry about an imminent credit crunch. A Fed survey of senior loan officers on Monday showed that fewer banks tightened lending standards last quarter, while demand for commercial and industrial loans stopped deteriorating.

And “taking the froth off stocks” after roughly 20% gains for the year through mid-July is “what the Fed wants,” Rabobank global strategist Michael Every wrote Monday.

Still, any continued downturn in riskier assets could erode companies’ appetites to hire, and consumers’ readiness to keep spending, adding to the danger of an economic downturn. At one point, over the span of three weeks, some $6.4 trillion had been erased from global stock markets.

“The narrative of weaker activity and recession fears could become self-reinforcing,” said Robert Sockin, senior global economist at Citigroup Inc. “While this time might be different, the global economy has shown remarkable resilience time and time again in this cycle. A bit more wouldn’t be too surprising at this stage.”

Interest-rate futures show traders are now expecting at least a full percentage point of Fed easing by year-end. Investors have also added to rate-cut bets from the Bank of England and European Central Bank, both of which have already eased policy once this year. 

Rob Subbaraman, head of global markets research at Nomura who was at Lehman Brothers during the 2008 financial crisis, said the mix of slowing economic growth, still elevated interest rates, rich market valuations and sudden sentiment swings is an environment where “things can break.”

“It’s an environment where defaults can start to become more significant, and that can feed back into the economy,” he warned. “We haven’t had that yet. But I feel the environment’s becoming a bit more ripe for where we can start to see stresses in the financial system.”

The current cycle has already witnessed market-driven accidents. Such worries might stoke memories of March 2023 for example, when some regional US lenders buckled under the strain of rising borrowing costs, spurring a wider crisis of confidence that then brought down Credit Suisse. 

For now, observers including HSBC Bank Chief Multi-Asset Strategist Max Kettner insist the underlying foundations of the global economy haven’t really shifted, and there’s no cause for alarm.  

“We’re not really seeing things falling off a cliff — in fact when we look at most of our global leading indicators, US leading indicators, most of them are still either flat-lining or still going up,” he said on Bloomberg Television. “Collectively we probably should all be taking a bit of a chill pill.”

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