The risk of stagflation is more relevant than ever

The reaction of the markets to the Fed’s announcements yesterday says a lot about the extreme nature of their expectations: the Fed increased its Fed funds rate by 50bp and its chairman announced that it would most probably repeat this operation in June and then in July, knowing that it will begin to withdraw liquidity from the market at the same time. As a result, the US equity markets rebounded by 3%, the dollar fell sharply, with the EUR/USD exchange rate rising above 1.06 and long-term rates eased, in particular the 2-year rate, which lost 15bp to 2.65%. The markets were already anticipating three or even four 50bp rate hikes by September. They seemed reassured by the fact that Jerome Powell said that a 75bp hike was not on the cards.

US 2-year treasury rate vs US Fed fund rate

But can this optimism withstand the avalanche of bad news: China’s Caixin services PMI collapsed to 36.2 in April, underlining once again the devastating impact of anti-Covid measures on activity. In Europe, while the decline in French industrial production in March (-0.5%) is hardly surprising, the sharp drop in German industrial orders (-4.7% mom) does not bode well for Q2. The combination of a sharp economic slowdown and strong monetary tightening should inevitably continue to weigh on equity markets.

After the Reserve Bank of Australia on Tuesday, the Fed and the Reserve Bank of India India, the Bank of England is expected to raise its base rate by another 25bp today.