European and US indices were dragged down yesterday after the European Central Bank (ECB) raised interest rates by more than expected, at a time when fear of an economic crisis is heightened.
The market was taken aback by the ECB’s 50 basis point increase in interest rates yesterday.
Fear of a worldwide financial catastrophe gripped the market after the significant uncertainty created by Silicon Valley Bank’s bankruptcy and the Central Bank of Switzerland’s bailout of Credit Suisse. As a result, the market was betting on less aggressive hikes by central banks so they could avoid the embarrassment of the alleged severe liquidity situation that some banks in the US and Europe could find themselves in. However, the ECB did acknowledge the possibility of contagion if the climate of uncertainty persists and that some European banks could be vulnerable.
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Yet of all the options under consideration, the ECB’s decision yesterday, which includes a pause in rate hikes, is the most aggressive.
Since the ECB acknowledges that it is ready to take action if the liquidity situation in the banking system deteriorates, the bank’s recent decision is somewhat debatable. This points to the fact that the ECB had admitted that the worst-case scenario could happen while maintaining that it has all the resources needed to handle such a case. A large number of analysts believe that the increase in interest rates should have been limited to 25 basis points in order to prevent overfly tightening financial conditions and to allow some time to pass for events to play out before making further decisions.
Following the ECB’s statement, the market immediately reacted angrily with declines in the European indices that also pulled down American ones and also a decline of the euro and buying of bonds as safe-haven assets. This pushed the yields of German bonds to daily lows.
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The risk sentiment did, however, improve throughout the session as all the information was processed. On the plus side, the ECB's decision can be seen as evidence that it does not consider the financial situation in Europe to be alarming.
Now, the market’s focus is currently on what the Federal Reserve will do at its meeting next week, namely whether it will follow the ECB’s lead, a move that will not be well received, or whether it will decide to leave interest rates steady.
The announcement that JP Morgan and Morgan Stanley are in discussions to bail out First Republic Bank, one of the American banks threatened in the latest crisis, helped to boost market risk sentiment yesterday.
The Nasdaq 100 saw gains close to 2% as a result, adding to its previous four days of gains, and this caused Wall Street indices to rise.
Sources: Bloomberg, Reuters