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Markets got a big dose of reality this week, and it shouldn’t have been a surprise if investors had been listening to Fed officials over the past six weeks. It was crystal clear that the Fed intended to hike his forecast for the overnight rate is higher than he predicted at the September FOMC meeting. Based on comments from several Fed officials, it was also clear that those predictions on the dot plot would hold. be 5% or higher.

However, the market shrugged off the message, with the S&P 500 rising on weaker currencies and the dollar, which has eased financial conditions since mid-October. But that came to a halt this week, with the Fed’s dot plot forecasting rates at 5.1% through December 2023. On top of that, the ECB dealt another blow to the markets the next day, sending interest rates higher in Europe and stock indexes falling. .

Cumulative effects

The cumulative effect of tightening financial conditions and the reluctance to take these two central banks seriously will likely lead to a meltdown of the entire rally since mid-October.

The rally was based on the idea that the slowdown in interest rate hikes indicates that the Fed, ECB and nearly all central banks around the world are signaling that the end of the rate hike cycle is near. Instead, ECB President Christine Lagarde was asked at the press conference about the slowing down of rate hikes. he said:

Thank you for your question, as it helps me clarify one thing. Anyone who thinks this is the core of the ECB is wrong. We don’t spin, we don’t waver.

The message was stern and direct, and in case of confusion, he also stated:

So I know it’s tempting to assume that, oh, well, all central banks are doing the same thing at the same time. Not so much. The ECB does not rotate.

He even threatened a multiple rate increase of 50 bps, saying:

Based on the information that we have today, it’s forecast at our next meeting and possibly after that and maybe another 50 basis point rate hike after that, but that will also be determined by the review of the data. So don’t think it’s a one-off 50; it’s more than that.

Of course, markets weren’t expecting such hawkish comments from the ECB, especially from Lagarde, who tends to lean on the dovish side when interest rates explode upward in Germany and Italy.



It sent the German DAX sharply lower; Around the same time, US S&P 500 futures posted another sharp decline on December 15. The combination of Fed and ECB messages appeared to be too much for equity markets. It was a clear message that the fundamental assumption made in mid-October that central banks were going to be “pivotal” was completely wrong.

stock indices


It leaves the Fed on a clear path above 5% and the ECB, which does not appear to be over. Therefore, equity markets are too expensive for the amount of financial tightening that is likely to occur in the coming weeks. When financial conditions tighten, they cause stock prices and valuations to fall.

financial conditions


Too bullish on inflation

Unfortunately, this is the reality where markets are and have been until 2022, and it will likely be the best part of 2023 until central banks signal that they are willing to let financial conditions ease. If financial conditions ease through market forces before central banks are ready, it seems likely that they will step up hawkish commentary, threatening more rate hikes and possibly precipitating a second round of balance sheets.

Not only that, but it may only take one lackluster inflation report to spoil things for the market. Mary Daly of the San Francisco Fed said on Dec. 16 that she’s not sure why the market is so bullish on inflation and that pricing appears to be perfect.

Indeed, the market seems to be pricing in perfection. Inflation swaps are priced for inflation to land perfectly and go down to 2.55%. Even more amazing is how fast. In just seven months on the market, inflation will drop to 2.55%. That 7-month swap pegged inflation at 4.7%, up more than two percentage points, on Nov. 9, the day before the October “surprise” CPI print. One bad CPI print will be all it takes to raise these expectations again.

inflation swaps


Until the Fed and ECB loosen their grip on financial conditions, it will be difficult for equity markets to see sustained growth. There may never have been a better time not to fight the Fed than now.


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