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The Tell: First thing Fed breaks with higher rates will be the financial markets, BMO says

Source: iStockphotoThe Federal Reserve is the proverbial bull in the china shop, prepared to create damage with higher interest rates to bring down the hottest inflation spell of the past 40 years.The first thing that will break is the financial markets, “as currently unfolding,” BMO Capital Markets economists Michael Gregory and Sal Guatieri said in a note Monday. Dow industrials were on the brink of falling into a bear market, while the S&P 500 index and Nasdaq Composite are already in one; a dollar at more than 20-year highs is causing havoc around the world; and lending conditions are tightening as more Treasury yields rise above or touch 4% — the level some see as sending shivers through investors.Financial markets continued to search for positive momentum on Monday, after U.S. stocks closed sharply lower in Friday’s session and ended with weekly losses. The three major indexes DJIASPXCOMP were mixed in morning trading, while the 7- and 20-year Treasury yields briefly reached 4% on Monday as 2- and 3-year rates climbed further above 4.2%.“Based on our in-house measure, financial conditions are set to carve 2 percentage points from U.S. GDP growth next year,” Gregory and Guatieri wrote. “This reflects the punishing effects of the mighty greenback, the angry bear market in equities, wider credit spreads and tighter lending conditions, and assumes another 150 bps (basis points) of Fed rate hikes and a 15% slide in house prices. At the very least, the financial clouds have the words ‘shallow recession’ written all over them.” They see the U.S. posting back-to-back declines in quarterly real GDP in the first half of next year, and the unemployment rate rising to 5% from August’s 3.7% level by late next year.Reached by phone on Monday, Guatieri, based in Toronto, said “we’ve already seen financial conditions come under undue pressure, with the S&P 500 down more than 20%, bond markets very weak, and corporate credit spreads widening significantly. It all points to a much weaker economy in the year ahead.” The BMO economists now see the Fed ending its rate hike campaign between 4.5% to 4.75%, three-quarters of a percentage point higher than they had previously expected. The additional 75 basis points in hikes will turn out to be the “straw that breaks the camel’s back,” to use another proverb. And the world’s largest economy “is past the point of rescue” as the Fed pledges to restore price stability at all costs, they said.

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