It may have to. As noted last week, global financial conditions are tightening at spectacular speed under pressure on all fronts from Ukraine sanctions, the Fed and q rising DXY:
This is hammering peripheral global credit spreads and it’s working its way back to the centre as well::
Yet this is all happening before the Fed has even hiked once while US inflation is raging and US financial conditions remain obscenely easy:
Two things are obvious to me:
- The Fed is going to hike to reduce demand and fight the risk of a wage-push inflation cycle.
- The global economy is going to blow up earlier than the US does and, as a result, we’re seeing credit weakness much earlier in the tightening cycle than is usual.
How would the Fed deal with this if it persists? On the one hand, it would want to keep tightening for US conditions. On the other, it needs to loosen for the world (and possibly its own markets).
As Deutsche notes, markets are onto this in a sense:
…markets are now pricing the Fed funds rate to be 36bps higher from 2023-2024 than 2025- 2026. Markets are expecting the Fed to have to quickly cut rates shortly after the hiking cycle begins, which looks like a hard landing.
But it’s all too far away. The Fed can’t hike seven times this year without turning the Chinese economy into a smoking crater by H2, 2022.
As China responds with more PBoC cuts to softening external demand landing upon an already weak domestic economy, CNY will begin to fall and amplify weakness throughout the EM complex, especially in credit spreads.
That would normally be more than enough to sink commodity prices and start to bring inflation relief to the Fed such that it can stop tightening. That is still the base case.
But if the US labour market is as tight as the Fed fears then that may not be enough to satisfy it that it has inflation under control.
There is also the risk that sanctions trigger global market events long before the Fed is satisfied with the same.
In short, there is a risk case in which the Fed is forced to keep lifting interest rates for the real US economy even as it starts printing dollars for markets and everybody else.
I reiterate that this is a risk case but if it were to happen then the major outcome would be a lower DXY than otherwise, and higher AUD and commodity prices than otherwise, either inhibiting or inverting the latter two’s typical end-of-cycle hedging role.