by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the Bank of England’s decision to purchase bonds to maintain financial stability. Next, we will discuss the Federal Reserve’s role in the global economy and how its monetary choices could impact other central banks. Lastly, we review growing geopolitical risks in Europe and Asia.

BOE to the Rescue: The central bank’s market intervention will benefit investors but weaken the bank’s ability to fight inflation.

• The Bank of England announced that it would start purchasing long-dated government bonds to minimize risk to financial stability on Wednesday. The move was aimed at calming markets after the government released its plan to cut taxes by the most considerable amount in half a century. Before the BOE’s action, the pound sank, and gilt yields surged over concerns that fiscal spending from the newly released tax plan would exacerbate inflation. Although the markets have been relatively tamed due to these actions, we cannot rule out an emergency rate hike from the central bank.
  • Despite pressure to reverse the tax plan, U.K. Prime Minister Liz Truss has vowed to stick with it.
• Financial markets initially responded positively as fixed-income investors interpreted the BOE’s move as a signal that it would act in times of crisis. As a result, the pound rebounded from $1.04 on Monday to $1.08 on Wednesday. Meanwhile, the yield on 30-year gilts fell from 5.1% to 3.9% in the same period. The bank’s intervention relieved market participants, such as pension funds and mortgage lenders, that were struggling to cope with higher borrowing costs. However, if the central bank holds to its word to end the bond-buying program after two weeks, we will likely see a return to market turmoil in October.
  • Despite the bank’s involvement, the five-year U.K. credit default swaps spread increased to its widest level since the 2016 Brexit vote.
• The BOE’s actions are evidence of a trend among central banks to maintain some level of policy accommodation as they collectively hike interest rates to counter inflation. For example, the European Central Bank and the Federal Reserve have developed similar policy tools to ensure that their respective financial markets continue to run smoothly. The bank’s decision to inject cash into the market while tightening monetary policy indicates that they are not fully committed to maintaining price stability if it can lead to a financial crisis. As a result, inflation will likely be more challenging to contain, forcing banks to become more aggressive in their rate hikes.

Fed Fallout: Although much attention is paid to the BOE’s solo act on Wednesday, it is essential to remember that the Fed is still the conductor of the financial orchestra.

• Non-U.S. central banks are exploring ways to protect their economies against a strengthening greenback. Over the last few months, tight Federal Reserve monetary and rising geopolitical risk in Asia and Europe pushed up the dollar’s value to a twenty-year high, much to the annoyance of other countries. On Wednesday, the People’s Bank of China warned investors that it would defend its currency from speculators, and Taiwan’s central bank walked back claims that it would impose foreign exchange controls. In the West, calls for a 75 bps hike from the ECB officials grew louder.
• Although the recent BOE actions have led to a global bond rally, it is not likely to last. Around the world, countries are coping with elevated levels of inflation and a weaker currency. To prevent inflation from rising and capital from leaving these countries, central banks will have to implement aggressive monetary policy, especially for developing countries. Thus, tighter financial conditions will weigh on global growth.
• The push by central banks to contain the rise of the dollar could harm financial assets, particularly in developing countries. The capital flight toward safety led to a steep drop in investment in emerging markets throughout the year. Data collected from Bloomberg showed that every asset class within the MSCI Emerging Market Index is on pace to post a negative return for 2022. The poor equity performance in these countries will likely continue as the Fed tightens and the dollar strengthens; however, investment opportunities will be available if these trends start to slow or even reverse in 2023. Although we are not forecasting an imminent change in the dollar’s trajectory, we would like to remind investors that the dollar cannot rise forever or, as the saying goes, “whatever goes up must eventually come down.”

Geopolitical Turmoil: Frictions in Europe and Asia could pave the way to war.

• Abrasive actions from Moscow could pave the way for a direct confrontation between Russia and NATO. On Thursday, the Kremlin announced that it would formally annex several regions in Ukraine following the results of a referendum viewed mainly as a sham. This move by the Kremlin might be a precursor for a nuclear strike in Ukraine after Russia warned that it was willing to take extreme actions to protect its homeland. The U.S. has cautioned Russia that it would be punished if it followed through on its nuclear threat. Although it is unclear whether Moscow is bluffing, its recent setback in Ukraine and its vastly unpopular war mobilization suggest it is desperate to end the war.
  • As we mentioned in previous reports, wars are generally caused by miscalculations. Russia is more likely to use nuclear weapons if it believes that the West will not respond militarily. If Russia is wrong and uses nukes, it could lead to another intercontinental war in Europe.
• NATO warned of a collective response due to evidence that the Nord Stream Pipeline system was sabotaged. The remarks suggest that countries within the military alliance may view attacks on its infrastructure as a provocation. Although there is no evidence that the coalition plans to respond with force, it does indicate that all options are being considered. The sabotage of European pipelines is an example of the growing geopolitical instability within Europe.

• Tensions between North Korea and the U.S. threaten the global economy. Pyongyang fired two short-range missiles toward the East Sea. The hermit kingdom made the provocative move one day before Vice President Kamala Harris is set to visit the peninsula’s Demilitarized Zone. South Korean officials believe that North Korea will conduct another nuclear test in the coming weeks as Pyongyang has been readying its underground nuclear test tunnel. The U.S. and Japan are opposed to North Korea having nuclear weapons. Thus, the country’s steady advancement in its weapons’ development raises the likelihood of a preemptive attack. In the event of a conflict in the Indo-Pacific, supply chains and trade in the region will be disrupted. We will be monitoring this situation closely.

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