Market report: Will the sell off last?

European stocks have recovered some of their losses at the start of the new trading week, however, early expectations of a significant bounce back in US shares have faded somewhat as we move towards the second half of the trading day, and futures linked to the tech-heavy Nasdaq have turned lower. Thus, the selloff may not be over, and anyone who is hoping to pick up bargains in the tech sector may have to wait a little while longer. The key driver of this risk-off tone to markets is the prospect of tighter global monetary policy, rather than the latest Covid variant, and this could prove tricky for traders in the coming days as the Federal Reserve enters its quiet period ahead of its meeting next week. News that China had cut its reserve ratio has calmed markets to some extent, especially as there is likely to be more pain for Evergrande bondholders this week, however, the risks are mounting, and we expect risk sentiment to remain shaky in the coming days.

It’s time to find out who has been swimming naked in the pool of Fed liquidity

The sharp sell-off in stocks at the end of last week unnerved investors, especially as a weak payrolls report did not seem to put the brakes on market expectations about where Fed policy will go next. The Fed is likely to announce a faster pace of tapering when it meets next week, and financial markets are also pricing in a rate hike from the Bank of England. While the Fed’s asset purchases over the last 2 years have not directly led to asset price inflation, especially in tech stocks and cryptocurrencies, it has provided a backstop and sense of confidence, in that it’s worth buying the dips as liquidity has been so plentiful. Now that liquidity is being taken away, the backstop has gone and these stocks and other assets need to start trading fully on their own fundamentals. As the legendary investor Warren Buffet says, when the tide goes out, you’ll see who has been swimming naked. This is becoming applicable to the current market conditions, as the tide of central bank liquidity starts to pull back, there will be some naked swimmers out there and right now the market thinks that many of these are in the tech sector. It includes some relative newcomers including DoorDash, Zoom also fell sharply at the end of last week. However, some of the big tech titans have also come under pressure including Tesla, which fell 6% on Friday and is also expected to fall more than 1% at the start of the week based on pre-market trading. Bitcoin is also under pressure, with Bitcoin/ USD down more than 2%, the cryptocurrency is down more than 30% since its November record high. A mixture of record highs and Fed tightening is a tough mixture for Bitcoin traders to swallow, and there could be more downside to come as momentum remains on the downside. Ultimately, we think that the sell-off could stick around until we get clarity on how fast the Fed will tighten its monetary policy and how quickly it will taper its asset purchases. This has been reflected in the US Treasury market, on Friday the 10-year yield was down 10 basis points, on Monday it is up 4 basis points so far. This level of volatility in US bond yields is also likely to persist until we hear more from the Fed.

What to expect from the FOMC meeting?

While we will go into our FOMC market preview in more detail next week, we think that next week’s meeting, which will conclude on 15th December, is the biggest event in the medium term that will determine global market sentiment. The Fed could decide to double the pace of its taper program to $30 bn a month, and there could be initial discussions about when to tighten interest rates. The Fed chair Jerome Powell, said last week that inflation is no longer transitory and is the biggest threat to the US economy. We will find out whether inflation has continued to rise when the US November CPI report is released on Friday, the market is expecting prices to have risen by 0.7% last month, and the annual rate is expected to rise to 6.8%. The core rate of inflation, that strips out volatile elements like food and energy prices are expected to rise by 0.5% on the month, which would push up the annual rate to 4.9%. While these are big numbers and will make for uncomfortable reading for the Fed, we believe that the market has already reacted to the faster pace of Fed tightening, thus only a reading that was much higher than expectations could trigger panic sell-off at the end of this week, in our view.

Why the market may be too excited about US interest rates

Instead, we think that current expectations for US interest rates, with the first-rate hike expected to be in June, and a 30% chance that rates could be 75-100basis points by the end of next year (according to CME Fed watch), is perhaps too rapid a pace for the Fed for a couple of reasons. Firstly, the coronavirus is still with us and may dampen economic growth and hurt employment in the future, secondly, inflation could still prove to be transitory and we may not see prices rise at such a rapid clip in the second half of next year as annual comparisons start to weigh on the CPI rate. Lastly, we believe that the Fed will want to balance the need for tightening with avoiding a market panic, with 3-4 rate increases already partly priced in for next year, anything faster than that could dent market sentiment and send volatility surging. Thus, we think that the FOMC will not want the markets to price at an even faster pace of rate hikes and it will need to moderate its message to bring that to the market’s attention when it meets next week. Thus, if the Fed does soothe market fears that it will overshoot when it comes to tapering, then we could see markets rally from the Fed meeting into year-end.

GBP could benefit from stronger UK GDP

Elsewhere, the pound could be in focus as we wait for October GDP, which is expected to come in at 0.5%. however, we think that growth could surprise to the upside largely thanks to a buoyant services sector, and an encouraging labor market picture even after the end of the furlough scheme. Supply chain problems may have weighed on the manufacturing sector; however, we expect this data to show that the UK economy is now back at its pre-pandemic levels. Of course, news of the Omicron Covid variant may have dented growth in late November and December, especially in the hospitality sector, however, we won’t know about that until early next year. A strong October GDP reading could weigh on EUR/GBP in particular, which has become stuck around the £0.8520 level. Key support on the downside can be found at £0.8390- the low from 24the November.