1994
This is the first time the FOMC has raised by .75% in one meeting since 1994. There are many similarities between then and now. In 1994 the Federal reserve also had a credibility problem, which was addressed in February 1994 when Alan Greenspan came out and announced a rate hike for the first time ever. Prior to this moment, monetary policy watchers had to guess if there was a policy change, and it took months to be sure to what degree. Then, like now, the FOMC had been viewed to be behind the curve on inflation. Despite the initial shock, the resulting hikes in 1994 set up the economy beautifully for a solid 6 year run of economic growth and balanced budgets (remember those). Perhaps the market response to June 2022 echoes that sentiment from 1994. That is a very optimistic view and the chances of that outcome are not great.
A little perspective
US Monetary policy is still very accommodative. A series of .75% hikes to the discount rate look scary. But let’s not forget where we have been and more importantly where we are. We started from the most intense flood of money supply ever seen. Zero nominal interest rates and negative real rates. Even if we get each of the hikes that are priced in, that gets us to 3.5% in Fed funds. Those are still impressively low rates. The economy, the stock markets and anything else (don’t worry crypto we will get to you) should have no problem with funding and liquidity.
The housing market appears to be most vulnerable. Fixed rates for mortgages have exploded higher. In late 2021, you could get a fixed mortgage for 2.5%. Now it is north of 6%. The natural market remedy for higher mortgage rates is a return to floating rate loans. Regulations may be a bit of a hindrance to this. Banks are also more risk averse so that may limit supply as well. Again, rates are still very low by historical standards. The sticker shock will pass eventually.
Meanwhile in Japan
The Bank of Japan also met last month. Astonishingly, they not only failed to hike, but they doubled down on maintaining low rates and ample money supply for the foreseeable future. Apparently, they share the same view as Turkey in this regard. Throwing money into this situation is usually very dangerous, but it makes sense to give the BOJ some leeway here. Japan has not seen inflation in over 30 years until now. Any inflation in that time was desperately welcome, but never appeared.
The result is what we call the carry trade. It makes sense to borrow Yen at zero and lend it almost anywhere else in the world. This natural occurrence has been one of the key sources of market volatility over the past 40 years.
Currently, the relationships of the past are breaking down. Lower equity prices are typically accompanied by a stronger Yen. This usually is a result of funding from Japan being cut off due to fear of correction in global risk asset markets. The carry trade unwind was always reliable. So reliable that it will inevitably re-appear, and it could be the worst on record when it does.
Specifically, for USDJPY we can expect to see more USD strength for the rest of 2022. One of two things will happen:
- US inflation will recede, and US rates will flatten or go lower.
- US rates will go higher than expectations
Both point to higher USDJPY in the near term. Possibly much higher USDJPY. Sadly, it is likely to end in tears. A true carry trade build-up and unwind, could spell catastrophe for risk assets down the road. It could take a year or two or possibly more, but a rising USDJPY will eventually reverse
The strong US dollar is insulating us from even worse inflation. All globally traded commodities are priced in USD. When the USD strengthens, those commodities are cheaper in the US. Usually this creates a negative correlation between the dollar and commodities. Higher oil or gold generally mean lower dollar.
The reverse has been true this year. The likely cause is a more aggressive Federal Reserve rate hiking program compared to the rest of the world. Again, there are two possible remedies: a lower US Dollar or lower commodity prices.
Everywhere else
Central banks around the world are beginning to join the inflation fight. This should start to have a weakening effect on the US dollar. The Bank of Canada (BOC) most closely matches the US interest rate policy. However, the Canadian dollar has still slipped a bit the past 2 months. The Swiss National Bank (SNB) has also finally abandoned keeping the Swiss Franc artificially weak. The SNB has raised rates and even sold some equity positions in the past week.
The ECB is close behind, but their resolve does not look as strong as the rest of the world. The ECB faces a monumental task in executing interest rate hikes. The key problem is the divergence of sovereign interest rates in individual member countries. Any hikes will ripple across the continent in much different ways than the ECB may intend.
Unless central banks around the world can match the aggressive words and actions of the US, the US dollar will continue to rally. Inflation will be much worse for the rest of the world if the strong USD persists.
Crypto
It is hard not to talk about to talk about Crypto markets at the moment. It is also very difficult to choose a moment to catch one’s breath and make informed analysis. The crypto market is broken, or more appropriately, crypto is not a market at all.
The reality is that to treat this like other asset classes is a mistake. It was just a few months ago when Bitcoin and the like were touted as inflation hedges. Unfortunately, the opposite was true as the correlation was shattered. Maybe Bitcoin is a hedge for lower interest rates. A better way of looking at it is that it is so new, and so untested, with brand new participants. There is almost no regulatory oversight. The crypto market is open 24/7 so we see massive moves in very thin markets on a Saturday night.
There were a couple noteworthy events this past month that deserve some attention. Celsius, which is (was) an exchange for staking (lending) crypto, essentially collapsed earlier this month. Withdrawals were frozen and there is a ton of uncertainty as to whether participants will recover any of their principal. Luna was a top 10 cryptocurrency and it basically went to zero. Even more worrisome was that it had a linked stable coin, Terra (UST), that also went to zero. The losses for investors were staggering and the recourse is minimal.
These events were emblematic of a broken market. If they continue, as expected, it will be tricky for crypto currencies generally to find support. Another leg lower is possible, but it looks like we are closer to the bottom. Keep in mind that there are a lot of leveraged, low dollar investors getting stopped out of long positions right now. Most of the crypto supply is held by very long-term players who do not need to worry about price so much as high leverage speculators. Eventually these long-term holders will be able to step in and buy again.
Crypto currencies will have their day. For the moment, it’s best to watch and learn. Fortune favors the cautious too.
FX Market Commentary