The dollar has been on a tear this year as the Federal Reserve has pushed through 325 basis points of rate increases – superseding every other developed market central bank. Fed Chair, Jerome Powell has unleashed his inner Paul Volker (the head of the central bank in the late 70s/early 80s, credited with breaking the decade long inflationary cycle in the US). Unlike the last cycle, markets have consistently underestimated the pace of rate hikes.
Since the Jackson Hole meeting in late July, Powell and other members of the rate setting committee (FOMC) have been steadfast in their message. Inflation will be tamed, no matter the cost to economic growth. With the economy at or near full employment, the Fed is laser-focused on the other half of its dual mandate – price stability. With US inflation still above 8%, there is a real risk of unanchored inflation expectations. Once businesses and consumers believe inflation will remain high indefinitely, prices and wages can become self-reinforcing, creating a spiral that can take years to break. At this stage, the Fed believes the risk of doing too little outweighs the risk of going too far.
After more than a decade of “cheap money” which underpinned a bull market for equities and bonds, the pace of the pivot to much tighter monetary policy has caused ructions across global financial markets. US equity indices have fallen back to the June lows, as the prospect for a pause in rate hikes has diminished. The US dollar’s ascent to a 20 year high against a trade-weighted basket of currencies is, in itself, problematic due the currency’s global hegemony, ramping up the price of imports for the rest of the world. A key import for most countries is oil. Despite the oil price currently sitting nearly 10% below the level preceding Russia’s invasion of Ukraine, most countries are paying a higher import price due to the depreciation of their currencies.
The euro, yen and pound have been under the most pressure driven by a combination of factors. The surge in the cost of energy, particularly natural gas imports (LNG) have dramatically weakened terms of trade, eroded Japan, and Europe’s trade surpluses, while adding substantially to the UK’s deficit. Another important factor has been interest rate differentials. The Fed’s more aggressive rate hike path, relative to the rest of the developed world has widened the policy rate gap. The Bank of Japan’s stubborn continuation of negative interest rates and defence of its cap on 10-year government bond yields has weighed heavily on the yen, culminating in the BoJ’s first intervention to defend the currency in over 30 years last week.
Despite the Bank of England broadly keeping pace with the Fed, the pound sank last week after Finance Minister, Kwasi Kwarteng, announced the largest proportionate tax cut since 1972. Measures included scrapping the highest tax bracket, reversing the increase in the corporate tax rate, and abolishing plans to cap bankers’ bonuses. The tax cuts are expected to cost the fiscus £45 billion per year, which is in addition to capping consumers’ energy bills, which is expected to cost around £150 billion over the next year at current power prices. The pound dropped 4% on the day of the announcement and reached an intra-day low of $1.05/GBP on Monday morning, then recovering to $1.08/GBP.
Higher relative short and long-term rates in the US, together with an accelerating pace of bond sales (quantitative tightening or QT) continues to sap dollar liquidity from the global financial system – the opposite impact of quantitative easing (QE). Reduced liquidity pushes funding out of the most speculative areas first (think NFTs, crypto, meme stocks, venture capital) which began towards the end of 2021, before spreading to less speculative areas, which we are currently experiencing.
Central banks’ unrelenting focus on bringing inflation under control, despite a weakening economic backdrop, particularly in Europe, has raised the risk of recession. As a result, we expect heightened volatility over the next several months as tightening financial conditions puts pressure on equity valuation multiples. GDP is expressed in real or inflation-adjusted terms, which means nominal (or actual) growth can still be positive during a recession, which apart from the Global Financial Crisis, has predominantly been the case.
Companies’ results and their share prices are not expressed in inflation-adjusted terms. Share price declines during inflationary periods have historically been driven more by a de-rating rather than a substantial decline in earnings. When inflation is brought under control and central banks start cutting rates, equities have historically rebounded strongly.
