FX Trading focus: This Fed will hike until something breaks, and nothing is really breaking yet except for the yen.
Last week’s FOMC meeting was clearly not enough to impress the market, as Fed Chair Powell was already out yesterday in a speech and in a Q&A session with rhetoric clearly guiding more hawkish than he and the FOMC guided just last week. The Fed Chair mentioned his support for 50-basis point moves at coming “meeting or meetings”, argued that the Fed is prepared to hike “beyond common measures of neutral” if necessary and fretted that the further commodity price spikes driven by the war in Ukraine could destabilize longer term inflation expectations. The entire US yield curve lifted aggressively – the 2-year treasury yield is now more than twenty basis points higher than it was before his speech. And yet equities are bulling higher and high yield credit spreads tightened yesterday. The market is still giving the Powell Fed a “meh” rating on its impact here.
Back in my Q1 outlook, I trotted out the phrase that this Fed will hike “until things break”, a not very creative position based on the ample evidence of history, i.e., that is what the Fed generally does: it hikes until yield curves invert and the economy generally rolls over after some credit cycle excess that drives an asset market bubble. The one occasion the Fed got away with a fairly aggressive hiking regime without breaking something and achieving a “soft landing” was in 1994, when Fed Chair Alan Greenspan was on a mission to get ahead of the perceived risk of inflation from an economy heating up as the Fed fretted a surprisingly strong pick-up in long US treasury yields (inflation was not picking up at the time). The moves culminated with a 75-basis point rate hike in November of 1994 followed by the last move of 50 basis points in early 1995, bringing the Fed Funds Rate to 6.00% from its starting point of 3.00% at the beginning of 1994.
But there are few real parallels with the backdrop now versus then – now we have a positive output gap and raging inflation – at that time, inflation levels were muted, oil prices going nowhere, and the economy had just emerged from a recession a couple of years before. (To be fair to Greenspan, the unemployment rate in 1994 was dropping fast and closing in on the 1980’s lows, perhaps driving fears of an incipient overheating or wage-driven price spiral). As nothing malign emerged, the Greenspan Fed dropped the policy rate a couple of times in 1995, helping the genesis of the tech bubble to get under way. Every other time since the brutal Paul Volcker rate tightening regime of the late 70’s and early 1980’s, major Fed tightening regimes have eventually led to a recession. But the key difference between the 1994 Greenspan Fed and the 2022 Powell Fed is that the former was moving pre-emptively, not chasing a runaway train. The dynamic and risks of the latter are well described in a column today from Mohamed El-Erian at Bloomberg, who frets the consequences of the Fed having gotten so far behind the curve and dealing with the situation like an emerging market central bank.
What’s more, the Fed may have asset markets themselves in their sights as a way to bring inflationary risks down in the hopes that a “negative wealth effect” could cool demand. That point is well argued in the must-listen podcast of the week from Macro Voices on the Fed’s thinking as it launches this hiking cycle. The guest is Joseph Wang, a former Fed employee who worked on the Fed’s open market operations under the post-GFC QE regime. He makes a number of interesting and compelling points, among them that Fed rate hikes don’t impact the economy very quickly (private balance sheets are very healthy, for example, relative to normal cycles) and aren’t relevant for the supply-side limitations that are driving so much of the current inflation. Rather, quantitative tightening is perhaps more impactful when it arrives as it removes support from asset markets, leading possibly to the negative wealth effect that may be the Fed’s chief near term policy aim. If so, the Fed isn’t achieving anything yet if asset markets head higher still from here and it is a long wait until the May 4 meeting at this point. Indeed, the Fed will have to keep going until it gets ahead of the market – it’s a game of chase that will continue to escalate until the Fed gets the break it needs for credibility.
So as the Fed’s latest hawkishness hasn’t really made its market outside of treasury yields and on the Japanese yen (more on that below) and to a far lesser degree on the Euro, it is not particularly USD supportive and won’t be until or unless the Fed actually starts breaking things. Note AUDUSD gunning for new highs, for example.
The things Fed Chair Powell is trying to break do not include the Japanese yen, but that currency is breaking down badly in the wake of the jump in yields in the US due to the Bank of Japan’s yield-curve-control policy, under which 10-year JGB yields are capped at 0.25%. This leaves the yen to absorb the implications of higher yields elsewhere if JGB’s can’t. This could go anywhere in the near term (the 125+ high of early 2016 are the highest levels in the last almost twenty years) as long as US yields are spiking higher, but do keep in mind three things: the end of the Japanese financial year is fast approaching on March 31 (historically, a key seasonal effect), that the yen is at record low levels and does not feature the punitive negative real rates that have the Fed in such a policy bind and finally, that historically, Japan’s ministry of finance does not like excessive volatility or “disorderly” moves in the exchange rate and could change its mind at any time.