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FX: What happens when a tightening cycle ends before inflation is defeated

Picture of John Hardy
John Hardy

Head of FX Strategy

Summary:  Bank challenges have effectively ended the tigthening cycle, but inflation is still high. This brings forward a very challenging policy environment for central banks, which may generate different outcomes for different forex pairs.

The central bank tightening cycle has effectively already reversed as a function of lower forward expectations. That cycle came to an end on the sudden meltdown and official intervention over two consecutive weekends to avoid systemic risks stemming from failed or failing banks, in the case of Silicon Valley Bank and Credit Suisse, respectively. These situations arrived with such speed and impact that we have seen some of the most violent moves in US interest rates at the short end of the yield curve in market memory. Indeed, the central bank tightening cycle finally “broke something”. Unfortunately for policymakers, that something was pockets of the banking system rather than inflation. While bank funding challenges are likely to bring the recession forward, inflation will likely bottom at a very high level, presenting the worst possible policy challenge for central banks.

With perfect hindsight, the tightening cycle that kicked off in late 2021, but really didn’t accelerate until the summer of last year, was too much, too fast for the weakest links in the global financial system, even if the real economy was weathering the policy headwinds very well (as well as a number of emergency support measures, especially in Europe, that helped sustain inflation levels). But these new cracks in the system come at an awkward time for central banks, who are far from putting the inflation genie back in the bottle. Economies continue to absorb the monetary and fiscal policy excesses brought about by the pandemic, and new industrial policy and national security spending imperatives brought on by the Fragmentation Game that is the underlying theme of this Outlook risk aggravating inflation further from here. As fiscal austerity is out the window, not only on those imperatives, but also due to automatic CPI indexing of social transfer payments, inflation has sustainably reset to a higher, if probably far more volatile, level.

While a cessation of central bank policy tightening may be upon us, we’re not likely to see the kind of across-the-board celebration in risky assets that prior easing cycles have brought. First, sticky inflation will likely make it difficult for central banks to ease on anything close to the scale of previous cycles once we do get to an actual policy easing. Second, the market realisation that central banks will fail to get ahead of inflation and the ensuing setting of long-term inflation expectations higher will likely mean that long yields remain pinned at uncomfortably high levels, even if the economy begins slowing due to a credit crunch. It’s the worst of all worlds for central banks, which will be caught between the rock of inflation and the hard place of governments needing to continue to support the economy with deep-deficit fiscal spending. What do they do?

They all turn to the Japanese playbook in the end

Let’s consider the next slowdown, possibly brought about by a weakening credit cycle, but with funding expensive because of still-high inflation: eventually too expensive for governments to issue the scale of debt they will require for spending needs without destabilising bond markets. (Think Truss-Kwarteng bond response writ large). In any crisis, the sovereign must be funded, so the sovereign will be funded. And if bond markets ring the alarm bell, central banks must swing into action and will ultimately implement Bank of Japan-style yield curve control (YCC) on bond markets as they are reduced to mere accessories, or even enablers of the sovereign. The move may not be explicit at first, but it will be de facto. And it means we are now crossing the threshold into this new era in which central banks have lost their independence.

The yield levels in a new YCC regime won’t be anything like the BoJ’s -0.10% and 10-year cap of 0.50% (up from the 0.25% of the prior several years) but far, far higher. But they will still always be somewhere below the average inflation level, whether that means a policy rate of 3 and inflation of 6, or 4 and 7, or even 2 and 4, respectively. All sovereign governments need to deleverage either themselves (US, UK, parts of Europe, Japan) or their economies (everyone else in this bucket) or both (France!) and the only way to do so is via default (unacceptable), an enormous growth bonanza (impossible), or devaluation of debt through inflation (bingo).

In other words, we can never expect that central banks will manage to hike policy rates into meaningful positive territory nor tolerate the spending and nominal growth speed-limiters of high long rates. That spells an eventual yield curve control to both keep the fiscal side funded, and keep real rates negative. Negative real rates of negative two to three percent over a couple of decades can reset debt to sustainable levels. The game for currency investors will be to determine which currencies are likely to offer the least bad negative real rates and which assets can maintain the highest real returns (hard assets and companies that can raise prices at inflation or better) and which economies offer the most of these assets in a world engaging in the Fragmentation Game.

Chart: JPY on the road to recovery?

Q2 sees the dawn of a new era for the Japanese yen, and not just because Bank of Japan governor Haruhiko Kuroda is set to leave in April after ten years at the helm, but also as we are likely on the road to other central banks shifting, by necessity, to mimicking Bank of Japan policy, even if at different nominal yield levels. If so, this could help take the pressure off the JPY to some degree if lower and even negative long-term real (not nominal!) yield expectations become more embedded everywhere as we expect will be the case. Japanese investors may repatriate a portion of their immense savings if real yields elsewhere are unsatisfactory. This could allow a significant repricing of the broader JPY higher over the next couple of years, perhaps 10-15% in the CPI-adjusted Japanese yen real-effective rate index shown below.


What will this mean for individual currencies?

USD – The Fed was the most aggressive to tighten and at first blush, the USD may have the most to lose on the unwinding of policy expectations. But this turmoil and risk of a credit crunch have brought forward the eventual recession and the USD will still find pockets of strength as a safe haven through periods of market turmoil. The USD may only begin a more determined fall when the policy response is seen beginning to catch up during the next recession, though the USD peak was likely last fall.

EUR – In Q2, gone is the recent focus on late cycle ECB tightening. Instead, the EU could struggle with its enormous banks and bank funding/liabilities, with the risk that EU members move at different speeds to address the situation. The EU seems to always need a proper crisis to get a determined policy response. Neutral.

JPY – The BoJ paid a very heavy price for its YCC last year as it lost control of its balance sheet to enforce the policy, and the JPY paid the price. The Bank of Japan yield curve policies will still need adjustment higher if inflation stays at these levels, even as other central banks are seen “turning Japanese” as we argue above. General JPY outperformance expected over the coming year versus USD and Euro in particular.

GBP – The UK will prove more nimble in its policy response, as was seen in the wake of the Gilt/LDI crisis that brought the sudden end of the Truss-Kwarteng government. Still, the UK structural backdrop remains alarming, although it is difficult to determine how much of that alarm is already in the low price.

CHF – The SNB-arranged UBS takeover of Credit Suisse put the central bank’s balance sheet on the line with a string of guarantees. Luckily for CHF, that balance sheet is enormous, but the franc may be set to absorb some weakness in the near term on this move and the ongoing fallout, also as the Fragmentation Game may not be kind to Switzerland’s traditional all-welcome banking model, as the country will have to increasingly choose sides, as it did on Russia’s invasion of Ukraine.

The commodity dollars AUD, CAD and NZD – These may all see a race against the attractiveness of their hard asset commodity exports on the positive side with the negative side of high levels of private debt and the risk from a housing correction, particularly in Canada and Australia.

The Scandies NOK and SEK – The most positive news for NOK and SEK could be a deeper local government bond market and a Norway and Sweden that require banks and other institutions to hold more savings domestically. A policy move in this direction could weigh more on the upside than any downside risks to Scandies from the usual vulnerabilities (weaker global liquidity in the eventual downturn). That’s not to say that it will happen. Still, NOK looks particularly cheap. With punitive real rates in Sweden in particular, the two countries would do well to address the portion of inflation driven by excessive currency weakness, even if the country is vulnerable to a systemic risks from an unwind of its housing bubble. A space to watch for the balance of the year!

CNH - One of the most anticipated developments in Q1 was the China re-opening story that was meant to crystallise in the wake of Chinese authorities’ decision to abruptly end its zero-tolerance policy on Covid. Indeed, many metrics from the Chinese economy show one of the sharpest improvements in activity from very low levels. But the steep comeback in equities faltered already by early February, and around the same time, rallies in commodity proxies meant to enjoy the Chinese recovery have fizzled badly as well. The Chinese recovery was always going to sit awkwardly with the Fragmentation Game theme as countries, especially the US and its security allies, including Europe, want to diversify all key supply chains reliant on China. Stability will always be China’s imperative, but the CNH likely has a very low ceiling as China’s currency is overvalued, as its policy can’t help but also “turn Japanese” to devalue the debt thrown off by the malinvestment of recent years. The USDCNH leaves Q1 in perfect mid-range against the US dollar, and China will likely want to keep it there.

EM currencies – There are too many EM situations to enumerate here, but EM currencies don’t have the leverage domestically, and negative real yields elsewhere will likely help keep them clear of trouble on the debt side of the leverage as inflation erodes the real value of their legacy debt. This should mean that EM countries that can keep interest rates meaningfully positive are likely to be able to attract investment even as they run current account deficits, offering excellent returns in coming years once we get through the turmoil phase of the eventually incoming recession of this cycle (which risks having been brought forward, as noted above, by the bank funding crisis risks). The Mexican peso, for example, got over its skis in the most recent cycle, in part on the enthusiasm for its less negative real rates as the Mexican central bank matched inflation levels with its policy rate, but also as the Fragmentation Game theme has already been in play there, as many investors see enormous potential for friend-shoring of production capacity by US companies, including Tesla.


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