Investors must re-assess risk-taking after the seminal events of last week. While central banks stepped up their efforts to tighten financial conditions, the U.S. Administration adopted a very aggressive trade stance, adding to investors nervousness. At a much later date, we may look back at this past week and conclude that de-risking started at this time. Let’s look at the decisions reached last week and how they will likely affect financial markets in the coming weeks.

The U.S. Federal is taking away the punch bowl. The Federal Reserve announced its seventh rate increase since 2015 and has signaled that it is not done yet; observers expect two or three additional rate hikes before year’s end. The 12-month US Treasury note reached 2.3%, a 10 -year high. As a result, the yield curve flattened further, as long-term bond investors smelled, if not an outright recession, a slowing down of future growth accompanied by low inflation. The process of yield curve flattening has been on-going for more than a year and with every rate hike, the spreads narrow further.

The Fed’s decisions do not operate just within the United States but affect all assets dominated in USD. Rising U.S. rates and the concomitant rise in the exchange value of the USD adds to the stress of emerging markets which have large outstanding debt dominated in USD. Turkey and Argentine have seen their interest rates soar as investors fear defaults in the future.

In addition, the Fed continues with winding down its bond-buying program. Withdrawing liquidity introduces another element of tightening and signifies to the markets—both stocks and fixed income—that the hour is late and the party is just about over.

The European Central Bank announced that it will end its bond-buying program in December. Late to the game of quantitative easing, the ECB has been very aggressive in swooping up sovereign European debt and corporate bonds. However, the ECB will continue to support negative short-term rates in the Eurozone, a sign that that region is not out of the woods as yet. Recent data reveals some weakness in the German economy and the political turmoil in Italy has introduced an additional element of uncertainty.

Japan continues with its quantitative easing program.  As expected the Bank of Japan re-iterated its policy of bond buying in the light of weak growth and subdued inflation, a pattern that has existed for many years. The BoJ would love to tighten financial conditions along with the Fed and ECB, but domestic conditions warrant continued monetary easing. In Japan’s case, risk aversion continues its decades long pattern.

The central bank policy shifts have put investors on notice that the financial backdrop is less favorable for assets. Bond funds experienced net withdrawals worldwide, as much as $5.5bn in the first half of June.[1] European bond funds were especially hard hit. Emerging market fixed income funds witnessed a continuation of their eight-week long outflow.

Enter Trump’s Trade War with Major Allies and China. Nothing can discourage risk-taking more than an aggressive and unpredictable U.S. trade policy. The introduction of tariffs affecting U.S.  trade with Canada, China, Europe and Japan will seep into the pricing of all assets. The irony is that as the trade war intensifies, U.S. economic growth will suffer to the extent that the Fed may be forced to back away from future rate increases and possibly re-introduce stimulus to ward off a recession. As yet the Fed has not publicly reckoned with this possibility, but, then again, the trade war just started.

[1] EPFR Global, June 13, 2018