Jerome Powell, Chairman of the US Federal Reserve, during a Fed Listens event in Washington, DC, USA, on Friday, September 23, 2022.
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As the Federal Reserve increases efforts to control inflation, causing the dollar to rise and bonds and stocks to plummet, raising concerns that the central bank’s campaign will have unintended and potentially dire consequences.
Markets entered a dangerous new phase last week, in which statistically unusual moves across asset classes are becoming commonplace. The sell-off in stocks grabs most of the headlines, but it’s in the gyrations and interplay of the much larger global currency and bond markets that trouble is brewing, according to Wall Street veterans.
After being criticized for being slow to acknowledge inflation, the Fed has embarked on its more aggressive series of rate hikes since the 1980s. From near zero in March, the Fed has pushed its benchmark rate to a target of at least 3%. At the same time, the plan to unwind its $8.8 trillion balance sheet in a process called “quantitative adjustmento QT, which sells securities that the Fed has on its books, has eliminated the largest buyer of Treasuries and mortgage securities from the market.
“The Federal Reserve is breaking things,” he said. Benjamin Dunn, a former hedge fund chief risk officer who now runs consultancy firm Alpha Theory Advisors. “There’s really nothing historical that I can point to about what’s happening in the markets today; we’re seeing multiple standard deviation moves in things like the Swedish Krona, Treasuries, oil, silver, like every day. These they are not healthy”. does it move”.
For now, it’s the dollar’s once-in-a-generation rise that has wowed market watchers. Global investors are flocking to higher-yielding US assets thanks to the Fed’s actions, and the dollar has strengthened while rival currencies weakened, pushing the ICE Dollar Index lower. Best year since its creation in 1985.
“Such strength of the US dollar has historically led to some form of financial or economic crisis,” Morgan Stanley Chief Equity Strategist Michael Wilson he said Monday in a note. Previous spikes in the dollar have coincided with the Mexican debt crisis of the early 1990s, the bubble in US tech stocks of the late 1990s, the housing mania that preceded the 2008 financial crisis, and the sovereign debt crisis of 2012, according to the investment bank.
The dollar is helping to destabilize foreign economies by increasing inflationary pressures outside the US, Themistoklis Fiotakis, global head of emerging markets and FX strategy at Barclays, said in a note on Thursday.
The “Fed is now in overdrive and this is supercharging the dollar in a way that, for us at least, was hard to imagine” before, he wrote. “Markets may be underestimating the inflationary effect of a rising dollar on the rest of the world.”
It is in this context of a strong dollar that the Bank of England was forced to prop up the market for its sovereign debt on Wednesday. Investors had been dumping UK assets since last week after the government unveiled plans to stimulate its economy, moves that work against fighting inflation.
The UK episode, which made the Bank of England the buyer of last resort for its own debt, could be just the first intervention a central bank is forced to make in the coming months.
There are two broad categories of concern right now: Rising volatility in what are supposed to be the world’s safest fixed-income instruments could disrupt the pipes of the financial system, according to Mark Connors, former global head of risk advisory at Credit Suisse. that joined Canadian digital asset firm 3iQ in May.
Since Treasuries are backed by the full faith and credit of the US government and are used as collateral in overnight funding markets, their drop in price and resulting higher yields could hamper the good functioning of those markets, he said.
The problems in the repo market most recently occurred in September 2019, when the Fed was forced to inject billions of dollars to calm the repo market, a essential short-term financing mechanism for banks, corporations and governments.
“The Fed may have to stabilize the price of Treasuries here; we’re getting close,” said Connors, a market participant for more than 30 years. “What is happening may require them to step in and provide emergency funding.”
Doing so will likely force the Fed to halt its quantitative tightening program ahead of schedule, just as the Bank of England did, according to Connors. While that would confuse the Fed’s message that it is being tough on inflation, the central bank will have no choice, he said.
The second concern is that irregular markets will expose weak hands among asset managers, hedge funds, or other players who may have been over-leveraged or taken reckless risks. While a blowout could be contained, it is possible that margin calls and forced liquidations could further cloud the markets.
“When you have the peak of the dollar, expect a tsunami,” Connors said. “Money floods an area and leaves other assets, there’s a ripple effect there.”
The growing correlation between assets in recent weeks reminds Dunn, the former risk officer, of the period just before the 2008 financial crisis, when currency betting imploded, he said. Carry trades, which involve borrowing at low rates and reinvesting in higher-yielding instruments, often with the help of leverage, have a history of explosions.
“The Fed and all the actions of the central bank are creating the backdrop for considerable easing right now,” Dunn said.
The stronger dollar has other impacts, too: It makes a large chunk of dollar-denominated bonds issued by players outside the US harder to repay, which could put pressure on emerging markets already struggling with inflation. . And other nations could dump US securities in a bid to defend their currencies, exacerbating moves in Treasuries.
So-called zombie companies that have managed to stay afloat due to the low-interest-rate environment of the past 15 years will likely face a “reckoning” of defaults as they struggle to raise more expensive debt, according to Deutsche Bank strategist Tim Wessel.
Wessel, a former New York Fed employee, said he also thinks the Fed probably should stop its QT program. That could happen if funding rates rise, but also if the banking industry’s reserves decline too much for the regulator’s comfort, he said.
Still, just as no one anticipated that a obscure pension fund trading would trigger a cascade of sinking UK bond sales, it’s the unknowns that worry the most, says Wessel. The Fed is “learning in real time” how markets will react as it tries to curb the support it has provided since the 2008 crisis, he said.
“The real concern is that you don’t know where to look for these risks,” Wessel said. “That’s one of the points of tightening financial conditions, is that the people who overextended themselves ultimately pay the price.”
Ironically, it is the reforms that emerged from the latest global crisis that have made markets more fragile. Trading between asset classes is rarer and easier to disrupt after US regulators forced banks to withdraw from proprietary trading activities, a dynamic that JPMorgan Chase CEO jamie dimond has repeatedly warned.
Regulators did that because banks took on too much risk before the 2008 crisis, assuming they would eventually be bailed out. While the reforms have de-risked banks, which are now much safer, it has left central banks with a much greater burden of keeping markets afloat.
With the possible exception of troubled European companies such as swiss creditinvestors and analysts said there is confidence that most banks will be able to weather the coming market turmoil.
What is becoming more apparent, however, is that it will be difficult for the US, and other major economies, to disengage from extraordinary support given by the Fed in the last 15 years. It is a world that Allianz’s economic adviser Mohamed El Erian derisively called “the-the earthof central bank influence.
“The problem with all of this is that it’s their own policies that created the fragility, their own policies that created the dislocations, and now we rely on their policies to address the dislocations,” said Peter Boockvar of Bleakley Financial Group. “It’s all a pretty messy world.”