Pro Perspectives 9/26/22

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September 26, 2022
 
I want to revisit an excerpt from my July 14 note (blue font), and then talk about how it's playing out. 

 
Pro Perspectives, July 14, 2022: 
 
The Fed doesn't have the appetite for big rate hikes. 
 
If they did, they would have acted bigger, and more aggressively already. High inflation environments, historically, have only been resolved when short term rates (the rates the Fed sets) are raised above the rate of inflation.  The Fed is currently almost eight percentage points behind.  We can only assume, at this point, that it's intentional.  
 
Also, when asked about the inflationary risks of QE, back in 2010, the former Fed Chair (Ben Bernanke) said dealing with inflation is no problem.  "We could raise rates in 15 minutes." 
 
They haven't [done that, i.e. a big one-off emergency rate hike]. 
 
Add to this:  The current Fed Chair has told us that they were going to aggressively attack inflation, by "expeditiously" raising interest rates, and "significantly" reducing the Fed's balance sheet.  They have done neither.
 
So they have the tools.  They understand the formula for resolving inflation.  But they aren't acting. 
 
Why? 
 
Even if the U.S. economy (including our government's ability to service its debt) could withstand the pain of nearly double-digit interest rates, the rest of the world can't.  That's it.  End of story. 
 
Capital is already flying out of all parts of the world, and into the dollar.  Is it because U.S. bonds are finally paying interest?  Partly.  Mostly, it's because the U.S. is pulling global interest rates higher, which makes sovereign debt more expensive (more likely, unsustainable), particularly in the more economically fragile emerging market countries.  Rising U.S. rates accelerate global sovereign bond markets toward default/ sovereign bankruptcy. 
 
And historically, sovereign debt crises tend to be contagious (i.e. you get a cascading effect around the world).  So far, we've seen defaults by Sri Lanka and Russia. 
 
This is why the Fed is talking a big game, but doing very little with rates.

Okay, let's fast forward to today.  The Fed has now raised the effective Fed Funds rate to 3.08%.  The balance sheet?  At this point, the Fed has scheduled to have reduced the size by $237.5 billion.  They done just $100 billion.  Inflation, of course, remains much higher than the Fed Funds rate.  So the Fed still hasn't delivered on the tough talk.  

As we've discussed, they haven't because they can't.  Still, as we discussed on Friday, they now may have even gone to far with the tough talk.

Projecting another 125 basis points of tightening in the U.S. over the next three months has destabilized global markets.  

U.S. stocks have traded to June lows.  More importantly, the vulnerabilities in Europe have become amplified.

We've talked about the vulnerabilities in Europe, specifically Italian debt. 

Yields on Italian government debt are spiking, now 40 basis points above the June levels – levels that prompted an emergency meeting by the ECB …
As we've discussed, this should trigger the ECB's new bond buying program, to curtail the rise in these yields, and protect the solvency of Italy.  But it will come at the expense of the euro. 
With that, the euro continues to trade to new 20-year lows.  Sovereign debt yields in the UK are also spiking, and the British pound is collapsing (down as much as 8% in the past two trading days, falling to 37 year lows).  And as we discussed on Friday, rapidly declining currencies tend to come with (ultimately) debt defaults (even with central banks putting up a fight). 
 
Where is the money going, that's leaving Europe?  The U.S. — into the dollar/dollar denominated assets.  It's a (global) flight to safety (somewhat positive for U.S. assets, very negative for global assets).    
 
So, this all heading in the direction that we discussed back in July (i.e. the excerpt copied in above). 
 
And to be sure, it has been triggered by the Fed.  They have miscalculated — even at the (still) relatively low levels on interest rates. 
 
Remember, back in 2019, after a shallow rate hiking campaign and attempts to "normalize" the balance sheet (from the Global Financial Crisis response), the Fed was forced to stop and reverse (to cut rates and go back to QE). 
 
The reason: Things started breaking in the financial system.  To be specific, we had this 300 basis point spike in the overnight lending market.
What's happening now?  Things are beginning to break in the financial system (this time sovereign debt markets). 

 
With that, the market will continue to look for the Fed chair to walk back on the hawkish rhetoric and projections from last week's meeting.  He had a chance on Friday, at the "Fed Listens" conference.  He said nothing. Powell is on the calendar for a prepared speech again this week — on Wednesday.