Pressure Cooker

“You’re not leaving much time to sort of look at each monthly release,” Charles Evans said Tuesday.

He was referring to the Fed’s 75bps rate-hike cadence, which, according to the September dot plot anyway, will almost surely continue at November’s gathering. “There are lags in monetary policy and we have moved expeditiously,” he added.

Evans was speaking to CNBC. Asked whether he was concerned about the prospect that the Fed isn’t waiting long enough to assess the impact of rate hikes on economic activity, he answered in the affirmative: “Well, I am a little nervous about exactly that.”

He was also asked directly about the pound and gilts. His interlocutor noted “evidence that what the Fed is doing is having repercussions [for] other countries, currencies and asset classes.” “Is the Fed going to break the market?” he wondered, on the way to being more direct: “Is the Fed now creating another global currency crisis or a further crisis in financial markets?”

It was a good question. As any regular reader will attest, I’ve asked it myself.

Evans paused. “This has been a very rapid increase in our short-term policy rate,” he said, before effectively refusing to answer the question. He said inflation is a problem, not just domestically, but globally. “I think this type of rate environment is going to be here for a while.”

Suffice to say the Fed isn’t yet ready to address turmoil in global currency markets in any direct, unequivocal way, although they’ll have plenty of opportunities over the balance of the week. Ultimately, they won’t be able to avoid it.

There was some respite Tuesday as bond yields fell, particularly in the UK, but I’d emphasize that this isn’t a case where a cathartic release in equities — a “throw-in-towel moment,” as Bloomberg put it — will be sufficient to clear the proverbial deck. Capitulation in stocks won’t solve burgeoning currency crises. I’m not one to toss out Jeremy Siegel quotes, but he was probably correct to suggest, on Monday, that the Fed is now “talking way too tough.”

I wouldn’t want readers to misconstrue my point, especially considering I’ve been a hawk since February 11, when I defected from the “transitory” camp in a flourish with “Jerome Powell’s Inaction Risks Irreparable Damage To Fed.” The Fed shouldn’t quit now, just when consumer inflation expectations have fallen, breakevens are down sharply and financial conditions are a one-way ticket tighter. If they can just hold the line for another six or so months, and if they get any help at all from core inflation, they may actually be able to claim some kind of Pyrrhic victory (e.g., 4-handle inflation and a 4% policy rate).

Right now, though, G-10 FX is melting down. Developed economies are at risk of spiraling import bills. The dollar’s increasingly graphic, Gladiator-style rampage has cut commodities off at the knees, but the indiscriminate nature of the slaughter means other countries won’t benefit. Have a look at the figure (below), which shows Brent in euros and pounds.

“The plunge in the pound is problematic for UK oil consumers,” Bloomberg’s Alex Longley wrote. “While Brent is now up a little less than 10% this year, it’s still up about 40% in sterling terms,” he added. “Oil refiners must buy crude in dollars, so the weakness of the pound effectively ramps up end-user prices relative to the rest of the world.”

That dynamic isn’t confined to UK oil consumers. It’s going on everywhere, and it’s precipitating a self-fulfilling spiral, where weaker currencies beget weaker fundamentals and back around, in a closed loop. If this continues (so, if the Fed doesn’t address the issue, because it’s hard to see how it resolves on its own), it’ll be self-defeating. The Fed will never make it to the peak Evans mentioned, and they certainly won’t be able to hold terminal for anything like what’s implied by the dots.

To be clear, this isn’t a dollar-funding problem. Rather, it’s an old school crisis in the making. It’s a problem “new,” macro-focused Zoltan might be inclined to write about, not an issue “old” Zoltan might pen an esoteric, technical note on.

BNY Mellon’s John Velis summed it up pretty well on Tuesday. “G-10 currencies have started to behave like their emerging market counterparts [but although] the Fed’s fight to curb inflation will likely last years, FX markets remain largely shielded from liquidity distress,” he wrote, adding that “despite all the policy uncertainty in Japan, Britain and the Eurozone, USD demand is not causing undue stress in cash funding markets.”

That’s all well and good, but, again, this is a more straightforward problem. The dollar’s too strong. And notwithstanding what looked poised to be a relief session on Tuesday, there’s every reason to believe it’ll stay strong until there’s evidence of coordination.

“Events in the UK highlight the pressure-cooker conditions facing non-USD currencies,” ING remarked. If you ask the bank’s Chris Turner,  the October 12 meeting of G20 central bankers and finance ministers is now a key event for markets. “Does the FX language in the communique get tweaked to express concern over disorderly FX moves?” he wondered.

That’s more than two weeks from now. And two weeks is a long time in FX.


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11 thoughts on “Pressure Cooker

  1. When some of us were studying economics, the models we were taught assumed a closed economy. With little or no recognition of global capital and trade flows. (Exhibit One was the Laffer Curve.) Unless the Ivory Tower Fed governors and staff have taken some refresher courses and updated their sacred models. they will have to be dragged kicking & screaming to do anything about the crisis they party triggered.

    1. I go back a bit farther. Had my first econ course in 1962 and the GNP at the time was ~450bil (imagine) and total US trade was less than the statistical error term in the total. We actually were a closed economy in those days. The largest exporter in the US was CAT and they didn’t hit half a bil.

  2. The Fed has now tried the two poles of acting dovish (25 bp increases) and talking dovish (2.75% terminal) to acting hawkish (75 bp increases) and talking hawkish (4.75% terminal, unemployment increase) in just 6 months time. Both have roiled the markets and neither has accomplished what they intended. In between, there is a yawning middle ground of acting a little more dovish while continuing to talk hawkish, including raising the possibility of inter-meeting hikes. And whatever they do, a lot less talk would also be constructive, as you’ve emphasized repeatedly.

  3. The Fed would be foolish and lose its remaining credibility if it backed off. Demand destruction is needed throughout the world, not just in the US. This will cause lots of pain but brief, intense pain is better than lingering pain. Have investors capitulated? No. Have prices of houses declined significantly? No. Why should ordinary workers settle for low wage increases when corporations raise prices significantly?

    1. I’m not sure you caught the gist of this article. The Fed cannot allow reserve currency countries to implode. Period. If the UK is forced into some kind of IMF program, and the euro ends up in a crisis and Japan is forced to crash out of YCC, what do you imagine that’s going to be like for global markets? And what do you reckon the fallout from that would be for Main Street? Not good. The UK isn’t Turkey. We can’t just let it go and chuckle, or we’ll be chuckling our way down to SPX 1,500.

      1. I do not know the currency markets, or their workings. But I do know that confidence in the pound has importance relative to the US dollar at the moment. Yesterday I had the idea that any action by the US to show of support for the pound, verbally and/or symbolically, even to merely imply that the US backs the UK and the pound, would be a meaningful statement. There would have to be some form of action behind such a proclamation. But by itself, the mere idea of the Fed working with authorities in the UK and the Eurozone would imply a collective desire to influence and stabilize the currencies.

  4. With Brexit, Liz Truss (and her “budget”), the potential of breaking the Northern Ireland protocol, etc., I doubt that the Fed can keep the UK out of some kind of IMF program and maintain any kind of credibility. The UK has truly and completely compromised itself. The Fed cannot provide natural gas to the EU; Germany may have to partially suspend industrial operations if Europe has a hard winter. If I might rewrite your comment, “The Fed cannot prevent (other) reserve currency countries from imploding.” What can the Fed do if Putin uses nukes on Kyiv and what would the euro do in this case? Would you propose (essentially unlimited) central bank liquidity swaps? Jawboning? Letting Buffet buy the UK?

    Could the UK, the EU, Japan, etc. help themselves? Possibly. The UK could dump the Tories and form a unity government, immediately apply to rejoin the EU, eliminate the proposed tax cuts, have the BOE raise rates now, etc. The EU governments could begin restricting industries, provide income support (e.g. Kurzarbeit) for workers, accelerate the construction of LNG facilities, etc. Japan could eliminate YCC. In each of these cases, the Fed could assist these countries after they have taken constructive steps.

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