Monday, March 27, 2023

The Fed pivot that wasn’t

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US investors: think you have it bad? Imagine trying to trade British or Canadian or Australian markets right now.

It’s a fairly common argument that the Federal Reserve is exporting inflation with its rate increases. Higher rates mean a stronger dollar, and other major economies aren’t in a great spot to have significantly weaker currencies amid a food- and energy-price shock. (The shock is especially severe outside the US, for various reasons.)

That leaves other global central banks with a dilemma. Do they also need to hike rates until something breaks to control inflation that’s partly exported? TS Lombard’s Dario Perkins lays out the challenges in a Thursday note:

If the Fed continues to raise interest rates into 2023, central banks in other jurisdictions will face an increasingly difficult dilemma. They can either abandon their efforts to match US monetary policy, which would risk a more persistent inflation problem, or continue to raise interest rates until something in their domestic economies/financial sectors eventually “breaks”. Some economies are poorly placed to handle these monetary tensions, especially those with large current account deficits, a heavy reliance on external funding, large/overleveraged financial sectors and domestic property bubbles. Central banks in these jurisdictions — which include Canada, Australia, the UK, New Zealand, the Nordics and a portion of the euro area — seem to be entering a “lose-lose” situation, with currencies likely to remain under pressure irrespective of their domestic policy choices. At this point, only a genuine Fed pivot can save them.

A “genuine Fed pivot”, eh?

Bit of a problem there, as Fed Chair Jay Powell said during Wednesday’s presser there’s “some ways to go”, and that rates may end up at a higher level than officials had previously forecast. The last round of dots had rates rising as high as 4.9 per cent next year.

The futures market has ratcheted up projections further, with the futures-implied rate up to 5.2 per cent by June 2023, the highest so far this cycle:

© Bloomberg

To be sure, it’s possible the dollar has overrun a bit. Financial markets are forward-looking, after all, so a slowdown in the Fed’s rate-hike pace could still help countries that import food and energy.

But just because the worst is over doesn’t mean global economies won’t still face stress. Perkins writes that “Canada, Australia, the UK, New Zealand, the Nordics and a portion of the euro area” could face especially severe pressure because of “current account deficits, a heavy reliance on external funding, large/overleveraged financial sectors and domestic property bubbles.” He continues:

Beyond the relative safety of US-denominated assets — since further dollar strength seems inevitable in the absence of a Fed pivot — there are few parts of the world that are likely to provide “safe-haven status”. Investors should probably favour the currencies of economies with strong trade positions, modest financial imbalances, and central banks that can defend their exchange rates without driving those economies into a recessionary death spiral.

Outside the US, some safer destinations for cash include Switzerland and Japan.

And even in the US, it will be . . . interesting to see how the economy fares with a 5-per-cent-plus fed funds rate. The view from the central bank appears to be that businesses have termed out their debt and consumers have been holding on to cash, so rates can grind higher with minimal pain.

Still, investment-grade bonds have posted a nearly 20-per-cent loss this year, investors are indeed withdrawing cash from open-ended funds, and analysts are starting to ask questions about how managers are marking their portfolios to market. The QQQs are down more than 30 per cent this year. And if Wednesday’s presser was any indication, things could get uglier.



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