Risk Appetite Plummets as Powell’s Hawkish Tone Rattles Financial Markets

Despite the European Central Banks' decision to raise rates further, which theoretically should have benefited European currencies due to the widening interest rate differential, investor interest in the dollar saw a sharp increase yesterday. During the second part of his testimony to Congress, the head of the Federal Reserve (Fed) aimed to address the communication gap regarding rate hikes this year and delivered quite hawkish comments. Powell focused on the prospects of short-term tightening and sought to align the market's interpretation of the updated Dot Plot with the intentions of Fed officials. It is worth noting that Powell succeeded in bridging this gap.Key statements from Powell's speech included:- It would be appropriate to raise rates twice more this year.- The majority of FOMC members believed that rates should be pushed a little further.- Fed Chair doesn’t see significant progress in service-sector inflation.As a result, the dollar index initially surged from 102 to 102.40, and today it has even challenged the downward trend by breaking above the upper boundary of the bearish channel.Gold prices declined to $1910 per troy ounce, while oil experienced a 4% drop yesterday. The absence of negative macroeconomic data is preventing stock markets from undergoing a correction. Futures on American indices are moderately negative, and European stock indices are also declining.It is important to highlight that simultaneously with the dollar's surge, the yield on long-term US Treasury bonds sharply declined. Following Powell's speech, the yield on 10-year Treasuries dropped by 10 basis points:Usually, the dollar strengthens alongside increasing yields on Treasury bonds as investors shift from bonds to cash, and the growing interest rate differential between US bonds and those of other countries (all else being equal) attracts foreign investors to US bonds. The market's risk appetite is high, with expectations of further economic expansion. However, when bond yields decline and the dollar rises, it indicates a prevailing trend of risk aversion. Investors reassess the likelihood of a recession and reduce exposure in risk assets. American investors divest from foreign assets and increase their demand for the dollar, while foreign investors perceive American assets as a safe haven and also buy the US currency. Powell's forecast of two rate hikes seems to have genuinely concerned investors about the economy potentially sliding into a recession due to excessive tightening. Markets are probably facing a situation where risk assets will be highly sensitive to deteriorating economic statistics, and the role of the dollar as a safe haven will significantly drive demand for the American currency.