Considering markets as we’ve come to know them over the past decade (or three) were built on a set of assumptions which no longer hold, asset prices have held up remarkably well in 2022.
That might seem like an odd thing to say. After all, the S&P came into the back half of the year on track for its worst real returns on record, investment grade credit is down an unthinkable 17%, currencies are a mess and a GDP-weighted index of global government bonds is currently on pace for the worst year since 1949.
And yet, when you take a step back and consider the sheer scope of the macro shift to which we’ve all borne witness, it’s apparent that things could most assuredly be worse. It’s possible, I think, that things may indeed get considerably worse, and relatively soon.
The inflation genie isn’t just rattling around, restless inside the lamp. He’s loose. And currently in the wind. Rate hikes to coax him back into the bottle have played havoc. With rates, obviously. And volatility there has knock-on effects for equities. But also with currencies.
Although assessing FX based on rate differentials and the relative footing of monetary policy across locales is nothing new (it’s part and parcel of the game), the rapidity, frequency and size of ongoing policy adjustments is. On Thursday, the SNB exited negative rates with a 75bps hike, as expected, but “whispers” about a larger move from the sometimes unpredictable institution (likely emboldened by the Riksbank’s 100bps move earlier this week), the threat of intervention in either direction to curb one-way moves and remarks from Thomas Jordan (who indicated that something would have to go seriously awry between now and December for the bank to consider an inter-meeting hike), sent the previously buoyant franc tumbling the most in seven years. The right-most shaded circle in the figure (below) shows the scope of the drop at the lows for the franc on Thursday. More to the point: It depicts a dramatic euro-franc short squeeze.
Recall that the SNB surprised markets with a 50bps hike in June, triggering the biggest rally since the bank scrapped the cap in January of 2015 (left-most shaded circle in the figure). Thursday’s plunge came on the heels of a virtually uninterrupted stretch of appreciation, so the point isn’t to suggest the franc is headed for any sort of sustained weakness. Rather, I wanted to emphasize the extent to which the door for anomalous price action is propped (wide) open. Anything can happen at any time in an environment where traders are compelled to price the relative implications of very large monetary policy adjustments on very short notice. That already daunting endeavor is complicated further by the necessity of appraising i) the likely evolution of inflation trajectories across locales (as well as what that’ll mean for future monetary policy adjustments) and ii) thinking through a given nation’s relative vulnerability to trade shocks brought on by weaker currencies and soaring commodity prices.
Thursday’s franc fireworks were just another example of this year’s ongoing FX tumult. Also on Thursday, the yen went for a wild ride as Haruhiko Kuroda’s obstinance on BoJ easing played tug-of-war with the first direct intervention from the finance ministry since 1998.
Earlier this month, I suggested the Fed was approaching a “you break it, you buy it” moment with the dollar’s roughshod run, which is predicated in no small part on ever higher US yields. That moment is close at hand, and it’s just another manifestation of the epochal macro shift, which delivered to the US the highest inflation in 40 years.
The Fed has no choice but to keep raising rates, and while some small locales are comparatively insulated (Switzerland being one of them, by the way), nobody is “safe” or “immune” or unaffected. At the end of the day, the Fed effectively sets monetary policy for the rest of the world. Currently, inflation realities mean everyone is compelled to move in the same direction anyway, but even if you wanted to, you couldn’t march to your own drum. For example, commentary on Thursday’s SNB hike invariably noted that the bank has now “matched” the ECB. Although the ECB will say it’s hiking to contain inflation, that’s inseparable from the dollar story for a number of reasons. The weaker euro (like the weaker yen) meant pass-through inflation, higher import costs and a deteriorating trade balance, all of which can feed more currency weakness in a self-fulfilling prophecy. Ostensibly, hiking rates can help, which is part of the rationale for ECB tightening. And, again, the SNB certainly takes the ECB’s posture into account.
It seems extremely unlikely to me that the current trajectory of US monetary policy — where the Fed continues to ratchet rates higher in what, just nine months ago, would’ve seemed like ludicrously large increments — is sustainable in anything like perpetuity. The Fed’s suggestion, as conveyed by the new dots, that the Committee can hold terminal for what, from a historical perspective, would be quite a long time (and keep rates in restrictive territory for even longer than that), comes across as highly implausible in a world where everything pivots on US monetary policy and virtually everyone is accustomed to Fed tightening cycles undershooting the prior easing cycle such that policy trends progressively more accommodative over time.
On some days, this being one of them, it seems a miracle to me (and not a small one either) that markets of all sorts haven’t simply broken down entirely this year. It’s not just the quantum of Fed hikes delivered over such a compressed time frame that’s concerning. What’s more unnerving is the possibility that inflation will prove to be an unruly, random phenomenon going forward due, again, to shifting macro dynamics, including de-globalization and geopolitical concerns. If US policymakers stick to the notion that rate hikes can contain inflation, and inflation proves to be even a semblance of random, then US monetary policy could become commensurately volatile, with a bias towards very high rates.
Nobody is thinking seriously about that. Well, almost nobody. “We have trust in an institution, the Federal Reserve, which is tasked with delivering price stability, and I think we are learning that, you know, can the Fed deliver price stability just by hiking interest rates? Or are there kind of forces in the real world, whether it’s a shortage of cheap goods, cheap energy labor, all these things, you know, is it as easy as raising interest rates from 0% to 5% to slow inflation down? Is it as easy as shrinking the balance sheet to slow inflation?” Zoltan Pozsar wondered earlier this month.
“This notion that the Fed can deliver 2% price stability… it’s an idea, and we will see if that’s indeed the case or whether we are going to settle in a period where 2% is not attainable,” he added. “And maybe 4% at some point is the new target. Or maybe we’re just going to be bouncing around between five and 10. I don’t know.”