Inflation: Why high key interest rates are wreaking havoc in the markets

This week was marked by a general decline in the stock markets. Investors reacted negatively to announcements by various central banks that they would raise their key rates. But why is this bad news for the markets? “Les Echos” evaluated in five questions.

1. Why did the Fed raise its key interest rate?

On Wednesday, the US Federal Reserve raised interest rates by 75 basis points. Their rates are now between 1.5% and 1.75%. Historic increase: We have to go back to 1994 to find such a sharp increase in prices.

When Fed rates rise, it becomes more expensive to borrow (for businesses, individuals, and the United States). This reduces the demand for goods and services, and therefore prices. Thus, the Fed hopes to rein in inflation that has become runaway.

Inflation in 2021 was associated with the sudden rise in the global economy after the pandemic and the rise in energy prices. At first, analysts believed that this inflation would gradually fade away. But since the beginning of the year, evidence of strong and lasting inflation has emerged. In the US, in May, prices rose 8.6% in one year, a level not reached in 40 years. Economists estimate that inflation will reach 5.2% over the entire year.

2. What about other central banks?

The trend towards tightening monetary policy is global. On Thursday, the Swiss National Bank followed suit with the Federal Reserve and made its first rate hike in fifteen years. The Bank of England has also begun to tighten policy. On Thursday, it announced a 25 basis point increase in its key price, which now stands at 1.25%.

For its part, the European Central Bank planned to raise key interest rates at its next meeting on July 21, before another hike in September. Money markets are expecting a 190 basis point hike in ECB interest rates by December.

3. What is the impact of monetary tightening on stock markets?

On both sides of the Atlantic, rising key interest rates sparked panic in the markets. In Paris, the CAC 40 fell 2.39% on Thursday, putting it 20% below its historic record high of 7,376 that was established on January 5. On Wall Street, stock markets also took the hit. The S&P 500 is down 3%, and has lost about 6% since the start of the week.

the reason ? Announcements from central banks made the markets fear of slowing economic activity and thus lower than expected growth expectations. Investors expect a decrease in the performance of companies and therefore a decrease in the value of shares. That is why they are discouraged from buying stocks”, explains Christine Revelart, an economist at the French Observatory of Economic Conditions (OFCE). The economist adds: “Investors will abandon securities in the stock market in favor of bond bonds, which are considered safer.”

4. What is the effect of higher interest rates on government bonds?

Countries, like individuals and companies, also borrow from financial markets. They issue debentures i.e. debentures on which they pay interest.

The yield on these bonds (i.e. the interest rates that a country pays to its creditors) corresponds to the countries’ long-term reference rates. Generally, it increases when key interest rates rise. In Europe, as in the United States, sovereign debt yields have at times jumped by 20 basis points to levels not seen since the beginning of 2014.

With that, the French rate on Thursday was about 2.25%. Italy’s figure was 3.73%, having topped 4% during the day. In the United States, the 10-year average is over 3.33%. With this rise in interest rates, the debt burden on public finances increases.

For states, it’s the end of an era in which debt hardly costs anything. In 2020, France financed itself – for its medium and long-term bonds – at negative rates (-0.14%). In other words, France made money by borrowing. That era is now over.

5. Why did the cryptocurrency market crash too?

The cryptocurrency market is very sensitive to the monetary policy of the Federal Reserve. First, cryptocurrency trading is becoming more and more professional, which is why the cryptocurrency market is increasingly following the path of stock markets. Thus, in April and May, the cryptocurrency market fell at the same time as the Nasdaq, the US index of technology stocks.

Moreover, due to the poor performance of the stock market, investors tend to restrict their portfolio of risky assets in an effort to limit the damage. Especially volatile and therefore risky crypto-assets are the first victims of this phenomenon. The main market cap, Bitcoin, which reached a record high of $68,992 on Thursday only traded at around $19,500. It has swept almost all cryptocurrencies in its wake. In total, the cryptocurrency market is now worth just $1 trillion, compared to three times what it was last year.

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