You Break It, You Buy It

The Fed is in the inflation fight for “as long as it takes,” Lael Brainard boldly declared Wednesday, during remarks for a conference hosted by The Clearing House and Bank Policy Institute in New York.

She didn’t specify how long “as long” will be, mostly because nobody, least of all the Fed, knows. Instead, she reiterated a set of (by now ad nauseam) talking points centered on the notion that the Committee needs to run restrictive policy for “some time” in the interest of reestablishing credibility and convincing the public that inflation “is moving down to target.”

Brainard spoke two hours after Wall Street Journal “Fed whisperer” Nick Timiraos effectively confirmed a third consecutive 75bps hike for this month’s policy meeting. At the least, Timiraos’s article was evidence that the Fed is leaning strongly in that direction. Brainard, perhaps playing “good cop,” said risks will become more two-sided “at some point,” a nod to the self-evident conclusion that outsized hike increments won’t be appropriate in perpetuity. She echoed the July FOMC minutes in flagging “risks associated with over-tightening,” while being careful to repeat the Fed’s commitment to avoid mistakes made in the 70s.

Notwithstanding Wednesday’s constructive price action in equities and concurrent bond rally (you can chalk the latter up to a partial reversal of Tuesday’s selloff, which was almost entirely attributable to a deluge of corporate supply), the Fed’s resolve is dangerously close to destabilizing global markets via the inexorably stronger dollar (simple figure below).

That’s the DXY. Bloomberg’s Dollar Spot Index hit a new record high earlier this week, before pulling back on Wednesday alongside US yields. Treasurys inherited a rally from short-end gilts (two-year UK yields responded to speculation that Liz Truss’s plan to cap energy bills will take some pressure off the Bank of England). Yields subsequently trundled lower with crude, which is now in a tailspin thanks in no small part to pressing concerns about Chinese demand (or, more aptly, a lack thereof).

Although the greenback took a breather on Wednesday, the situation is acute. The euro is in deep trouble amid the bloc’s spiraling energy crisis which, among other things, is manifesting in a self-fulfilling terms of trade shock. The pound is bedeviled by an almost comically dire domestic economic situation that Truss may or may not make immeasurably worse. The yen is in free fall. The PBoC is attempting to ensure the yuan’s date with 7.00 is an orderly, polite affair, to mixed results. The Bank of Korea is staring nervously at a 13-year low for the won. The Philippine peso weakened to a record. And so on.

The Asian Dollar Index is sitting near a two-decade low. As Nomura’s Charlie McElligott wrote Wednesday, these are crisis levels (the annotations in the figure, below, are Charlie’s).

“Asia currencies are now at COVID- and GFC- lows,” BofA’s Michael Hartnett said. “If oil’s drop is unable to ignite a bid for Asia oil importers, it’s a global recession signal,” he warned.

The knock-on effects are too many to list. One side effect is a ballooning spread between hard currency and local currency emerging market bonds. The stronger the dollar, the more expensive it is for countries who borrow in hard currency to service their debt. A Bloomberg gauge of EM hard currency bonds is down almost twice as much as its local-currency counterpart in 2022, on track for its worst year ever in data going back nearly two decades.

Note that in the current conjuncture, dollar strength risks turning developed markets into emerging economies. Weakness in the euro, pound and yen are contributing to soaring import bills and pass-through inflation, exacerbating the cost of living crisis in Europe and the UK, and fueling a yen spiral that looks increasingly untenable. For Australia, Canada and New Zealand, the pressure to keep hiking rates creates stability risks tied to property bubbles.

At this point, the Fed probably needs to be more concerned about “breaking something” in a wider context than about undermining the US economy which, if it rolls over at all, can’t possibly underperform Europe going forward, let alone the UK. If we knew what growth really was in China, we’d almost surely discover that the US economy is easily outperforming its closest competitor too. Insult to injury for other currencies is the distinct possibility that if the US finally does succumb to a recession, the rest of the world’s problems will be far worse, creating a safe haven bid for the greenback. Until then, it’ll keep benefitting from favorable rate differentials and relatively robust economic outcomes.

“The fact remains that the recent impulse tightening in global financial conditions via the US dollar and real rates likely won’t stop until either the Fed is able to signal a policy pivot, China truly eases with larger, more substantial stimulus and credit-pumping to improve fundamentals (but without ‘COVID zero,’ which is stifling any chance at recovery) and/or Japan caves and adjusts YCC or intervenes in the yen,” McElligott went on to write.

Commenting late Wednesday, BMO’s Ian Lyngen and Ben Jeffery said Brainard’s “in this for as long as it takes” rhetoric “speaks to the potential of over-tightening (and the implied risks).” “Despite two consecutive quarters of negative real GDP growth, policymakers remain resolute that the US isn’t in a recession,” they said, calling that “a moot point insofar as it would be unlikely to alter the path of hikes in light of prevailing balance of risks.”

At some point, the Fed will break something. They always do. And even if the US economy doesn’t look particularly fragile right now, virtually everything else does. In a crisis, the Fed is de facto central bank to the world. “You break it, you buy it” applies.