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Analysis: Markets must face up to tightening financial conditions

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© Reuters. A specialist trader works inside his post on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., March 10, 2022. REUTERS/Brendan McDermid/Files

By Yoruk Bahceli

(Reuters) – Already sitting on double-digit losses this year, stock market investors must brace for more, as the realisation sinks in that the U.S. Federal Reserve intends to tighten financial conditions to get on top of red-hot inflation.

Essentially, financial conditions measure how easily households and businesses can access credit, so are critical in showing how monetary policy transmits to the economy. Fed boss Jerome Powell repeated on Wednesday he will be keeping a close eye on them.

And they have a bearing on future growth – Goldman Sachs (NYSE:GS) estimates a 100 basis-point tightening in its proprietary financial conditions index (FCI) – which factors in rates, credit and equity levels as well as the dollar – crimps growth by one percentage point over the following year.

Goldman’s and other indexes from the Chicago Fed and IMF all show financial conditions have tightened significantly this year but remain loose historically, a testament to the scale of stimulus unleashed to help economies weather the pandemic.

Sven Jari Stehn, chief European economist at Goldman Sachs, estimates the bank’s U.S. financial conditions index will need to tighten somewhat further for the Fed to achieve a “soft landing”, i.e. to slow growth but not excessively.

Goldman’s U.S. FCI is at 99 points – 200 bps tighter than at the start of the year and the tightest since July 2020. Conditions tightened 0.3 points on Thursday, as shares tanked, the dollar hit two-decade highs and 10-year bond yields closed above 3%.

But they still remain historically loose.

“Our estimate is that the Fed basically needs to halve (the jobs-workers gap) to try to get wage growth back to a more normal growth rate,” Stehn said.

“To do that they essentially need to reduce growth to a rate of around 1% for a year or two, so you have to go below trend for a year or two.”

He expects 50 bps hikes in June and July, then 25 bps moves until policy rates rise just above 3%. But if conditions do not tighten enough and wage growth and inflation do not moderate sufficiently, the Fed may continue with 50 bps hikes, he said.

FCI looseness appears puzzling given market bets that the Fed will lift rates above 3% by year-end while running down its bond holdings, sharply higher Treasury yields and tumbling stocks.

But the S&P 500 still trades 20% above its pre-pandemic peak. Through the wealth effect, equity prices are thought to support household spending.

That may change – the Fed stopped growing its balance sheet in March and will start cutting it from June, eventually at a monthly $95 billion rate, embarking on quantitative tightening (QT)

Michael Howell, managing director at consultancy Crossborder Capital, noted that U.S. equity declines have tracked a 14% drop in effective liquidity provision by the Fed since December.

He estimates, based on pandemic-time stock rallies and recent falls, each monthly reduction could knock 60 points off the S&P 500.

The stock market “is certainly not discounting any further reduction in liquidity, and we know that’s going to happen,” Howell said.

UNFAMILIAR TERRITORY

The question is whether the Fed can tighten conditions just enough to cool prices but not so much that growth and markets are seriously hit.

A risk – highlighted by Bank of England policymaker Catherine Mann – is that central banks’ huge balance sheets may have muted transmission of monetary policy into financial conditions.

If so, the Fed may need to act more aggressively than expected.

Mike Kelly, head of global multi-asset at PineBridge Investments, noted that past QT episodes had been far smaller so “we are going into an environment that no one’s ever seen before.”

During the QT exercises of 2013 and 2018, stocks tanked 10%, forcing the Fed to ease back on tightening.

But those used to relying on the Fed “put” – the belief it will step in and backstop stock markets – should watch out; Citi analysts reckon this put may not kick in before the S&P 500 endures another 20% fall.

“Where you have 8.5% inflation… the strike price of the central bank put option is a lot lower than it used to be,” said Patrick Saner, head of macro strategy at insurer Swiss Re (OTC:SSREY).

Economy

Oh Snap! Social media stocks lose billions after Snapchat parent warning

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© Reuters. FILE PHOTO: A woman stands in front of the logo of Snap Inc on the floor of the New York Stock Exchange (NYSE) in New York City, NY, U.S. March 2, 2017. REUTERS/Lucas Jackson

By Nivedita Balu and Medha Singh

(Reuters) – Snap Inc (NYSE:SNAP) shares plunged more than 40% and sparked a sector-wide selloff on Tuesday after a profit warning from the Snapchat parent signaled tough times ahead for the once-booming digital ad industry.

The company was on track to lose $15 billion in market capitalization, while shares of major online advertisers and social-media firms were set to lose a combine $200 billion in value from the rout.

Meta Platforms, Pinterest (NYSE:PINS), Twitter (NYSE:TWTR) and Google-parent Alphabet (NASDAQ:GOOGL) were all down between 7% and 24%.

Snap said on Monday it was expecting to miss quarterly revenue and profit targets set just a month earlier and would have to slow hiring and lower spending.

The bleak view from one of the sector’s well-known names underlines the impact of the Ukraine war, surging inflation and rising interest rates on social media companies just when they were trying to shake off the hit from changes to Apple (NASDAQ:AAPL)’s iOS operating system.

“Snap is a proxy for online advertising and when you see weakness there then you automatically think Facebook (NASDAQ:FB), Pinterest and Google,” said Dennis Dick, a trader at Bright Trading LLC.

“Once you start thinking about Google, that’s when the markets starts to sell off.”

Tuesday’s selloff comes days after a Bank of America (NYSE:BAC) fund managers survey indicated investors are becoming increasingly bearish on tech stocks, a stark reversal to a bullish trend in the past 14 years.

Snap shares were trading at $13.3, lower than their 2017 IPO price of $17.

Analysts said Snap’s outlook for core profit suggested expenses will outpace its revenue growth, given headcount was up 52% in the prior quarter.

“There’s a lot to deal with in the macro environment today,” Chief Executive Officer Evan Spiegel said at a tech conference on Monday.

GRAPHIC: Digital advertising stocks this year (https://graphics.reuters.com/DIGITAL%20ADVERTISING-STOCKS/dwpkrnzogvm/Digital%20advertising%20stocks%20this%20year.png) cb55bba9-860d-4771-9546-5eaef7b68cf01

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Economy

As Fed amps up inflation fight, one policymaker urges caution

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© Reuters. FILE PHOTO: President and Chief Executive Officer of the Federal Reserve Bank of Atlanta Raphael W. Bostic speaks at a European Financial Forum event in Dublin, Ireland February 13, 2019. REUTERS/Clodagh Kilcoyne

(Reuters) – With the Federal Reserve amping up its fight against 40-year high inflation, one U.S. central banker this week urged caution so as to avoid triggering “significant economic dislocation” with interest-rate hikes that were too sharp.

“As we expeditiously return monetary policy to a more neutral stance to get inflation closer to our 2 percent target, I plan to proceed with intention and without recklessness,” Atlanta Fed President Raphael Bostic said in an essay released Tuesday on the bank’s website.

The essay set out in written form what he had laid out in an appearance on Monday: the case for raising interest rates by another half of a percentage point at each of the Fed’s next two meetings, as Fed Chair Jerome Powell has signaled, but then to pause on rate hikes in September to see the effects of tighter policy on the economy and inflation.

Monetary policymakers must be “mindful” of the uncertain effects of the pandemic, the war in Ukraine and supply constraints on the economic outlook, and “proceed carefully in tightening policy,” Bostic wrote.

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Economy

Stocks slump on growth concerns, bond yields slip

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© Reuters. FILE PHOTO: Men wearing protective face masks walk under an electronic board showing Japan’s Nikkei share average inside a conference hall, amid the coronavirus disease (COVID-19) pandemic, in Tokyo, Japan January 25, 2022. REUTERS/Issei Kato

2/2

By Herbert Lash and Lawrence White

NEW YORK/LONDON (Reuters) – Shares slid worldwide on Tuesday as supply chain woes and surging costs hurt corporate earnings and slowed manufacturing output, while Treasury yields dipped as the weakness in equities revived a safe-haven bid for U.S. government debt.

U.S. and euro zone business activity slowed in May, with S&P Global (NYSE:SPGI) attributing the decline in its U.S. Composite PMI Output to “elevated inflationary pressures, a further deterioration in supplier delivery times and weaker demand growth.”

Higher costs from surging freight and raw material prices led Abercrombie & Fitch Co to say it will continue facing headwinds until at least year-end, a day after Snapchat parent Snap Inc (NYSE:SNAP) said the U.S. economy had worsened faster than expected in April.

A two-day relief rally in equities was snuffed out as investors took note of sliding corporate profits on persistent supply chain issues, worsened by the Ukraine war, and soaring inflation that has forced consumers to cut discretionary spending.

The U.S. economy likely faces a sharp slowdown as the Federal Reserve hikes interest rates to stamp out inflation, according to David Petrosinelli, a senior trader at InspereX.

“It’s really all about a hard landing and the Fed really being boxed in the corner with only demand-side tools to help,” Petrosinelli said. “They really need to squash demand.

“This is going to have a ripple effect for the economy, which is why you’re seeing the price action in stocks and bonds,” he said.

MSCI’s gauge of stocks across the globe shed 1.69%, while the pan-European STOXX 600 index lost 0.99%.

On Wall Street, the Dow Jones Industrial Average fell 1.37%, the Nasdaq Composite dropped 3.33% and the S&P 500 lost 2.16% as it again headed toward a bear market.

Shares of Snap plummeted 41.1%, dragging down several social media and internet stocks, while Abercrombie fell 29%.

In Europe, utilities and commodity-linked stocks led declines but banking shares rose.

European Central Bank Chief Christine Lagarde said she saw the ECB’s deposit rate at zero or “slightly above” by the end of September, implying an increase of at least 50 basis points from its current level.

The comments came a day after Lagarde accelerated a policy turnaround that has seen her go from all but ruling out a move this year to penciling in several hikes.

“It has raised jitters in global markets about the possibility at least of a more aggressive move by the ECB,” said Phil Shaw, chief economist at Investec in London.

“There were reports overnight that some hawks on the governing council thought her comments yesterday seemed to rule out a 50-basis-point hike, but her remarks today appeared to leave that on the table,” he said.

Germany’s 10-year Bund yield fell 7.3 basis points to 0.951%.

Treasury yields fell to one-month lows as those on benchmark 10-year Treasury notes fell 13 basis points to 2.729%.

The dollar index fell 0.343%, with the euro up 0.38% to $1.073.

Lagarde’s comments in a blog post on Monday and a swing that drove the U.S. currency to two-decade highs reinforced tactical weakness in the dollar, said Bipan Rai, North America head of FX Strategy at CIBC Capital Markets.

“The broader macro backdrop still supports the risk-off take,” Rai said. “The dollar still has more room to run over the medium term.”

DISAPPOINTING DATA

Markets took some comfort from U.S. President Joe Biden’s comment on Monday that he was considering easing tariffs on China, and from Beijing’s continuing promises of stimulus.

Unfortunately, China’s zero-COVID-19 policy and its lockdowns have already done considerable economic damage.

JPMorgan (NYSE:JPM) cut its forecast for second-quarter Chinese gross domestic product to -5.4% from a prior -1.5% after disappointing data in April. On an annualized basis, its global forecast for the quarter is 0.6%, the weakest since the great financial crisis outside of 2020.

U.S. crude oil recently fell 0.05% to $110.23 per barrel and Brent was at $113.76, up 0.3% on the day.

Spot gold added 0.8% to $1,867.57 an ounce.

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