The Federal Reserve’s (FED) testimony on Tuesday was a painful wake-up call for investors, who had expected an end to rate hikes and a strong recovery in the year’s second half.

Now, the prospect of a 6% rate hike and keeping rates at a high level for an extended period of time to slow down the economy and bring inflation back to nearly 2% has become the central scenario.

The Fed’s latest message sets the stage for a half-point rate hike this month and contrasts sharply with the more dovish stance taken by its peers in Australia and Canada.
This also fuels fears of a hard landing for the U.S. economy as the bond market signals increasing risks of a recession. Investor expectations for rate swaps show that they expect a 100bp rate hike over the next four FED meetings. The yield curve inversion has, over the decades, anticipated recessions following aggressive Fed tightening campaigns. In the U.S., the gap between 2-year and 10-year yields posted a discount of more than one percentage point for the first time since 1981, when then-Fed Chairman Paul Volcker imposed hikes to fight double-digit inflation.

The Fed’s rhetoric will exacerbate the outlook for the emerging markets after Beijing’s modest economic growth target earlier this week dashed hopes of a recovery that had supported global markets. Higher for longer becomes the base scenario, and if this scenario materializes, emerging markets will suffer.

Markets were hoping for a pause and early cuts from the Fed this year. The wake-up call will be painful and should be reflected in market prices with a correction in stock markets.