by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment discusses how Brexit may have paved the way for Liz Truss’s brief stint at Downing Street. Next, we explain how the Fed’s monetary policy has forced central banks to accumulate greenbacks. Lastly, we conclude with an overview of countries adapting to the security threats posed by Russia and China.

 Now What? Liz Truss’s quick rise and fall in the U.K. may serve as a cautionary tale for other countries looking to exit from the European Union.

• The race to succeed Liz Truss as prime minister of the United Kingdom has commenced. The front-runners include previously ousted Prime Minister Boris Johnson, ex-Chancellor of the Exchequer Rishi Sunak, and Leader of the House of Commons Penny Mordaunt. Given the previous prime minister’s reckless fiscal policy, the markets will be hesitant to trust any new leader. So far, British bond yields have surged from Thursday’s low, while the British pound has dipped to $1.11. The new leader is expected to be picked by next week.
• The new prime minister will be the country’s fifth since the 2016 Brexit vote. After leaving the EU, the U.K. has not been able to establish its post-EU identity. The Theresa May government sought to blend pro-remain and pro-Brexit ideals, while Boris Johnson ran promoting a nationalistic agenda, and the short-lived Liz Truss wanted to bring back Thatcherism. The frequent shifts in identity show that the country is still unsure of how it will fit into the world separate from Europe. As a result, investing in the U.K. may be difficult as it isn’t clear what direction the country will go in the next five years.
• The swift market backlash that the U.K. faced following its decision to abandon economic fundamentals could lend to more support against an EU breakup. Consistently, Eurosceptics have argued that leaving the EU will prevent the need for draconian policies in favor of pro-growth policies. The recent selloffs in the British pound and bonds contradict these claims. Although this may not be enough to prevent Eurosceptics from complaining about the EU, it should be easier for the EU to push through free-market reforms in countries like Italy.

Central Bank: U.S. monetary policy has pressured central banks to hoard USD.

• The Federal Reserve’s hawkishness continues to grow as the central bank is determined to prove its inflation-fighting credentials. New Fed Governor Lisa Cook and Philadelphia Fed President Patrick Harker warned markets that the central bank is prepared to lift rates above restrictive territory and keep it there for some time. Investors responded to the remarks by placing bets that the Fed will raise its benchmark rate to 5% next year, which is 50 bps higher than median fed funds in the latest dot plots. That said, we think the talk is cheap. The Fed has not demonstrated that it can withstand the public scrutiny of raising rates during a recession. Thus, the Fed may pause sooner than the market realizes.
• The Bank of Japan is determined to squash speculators betting against its currency. The central bank signaled that it would intervene in FX markets for the first time since 1990 to prevent the yen from weakening further against the dollar. Currency chief Masato Kanda warned that the bank has limitless resources to protect the yen. As the largest holder of U.S. Treasuries, we suspect the bank could liquidate its holding to prop up the currency. Although this would be a temporary fix, the move would be another example of how reluctant the BOJ is to remove monetary accommodation to combat inflation.
  • The sale of U.S. Treasuries can lead to complications in the international banking system. For example, central banks’ usage of the Overnight Reverse Repo Facility retreated to $330 billion in the period ending October 19, down from an all-time high of $333 billion. The drop suggests that foreign central banks are withdrawing some of their cash holdings at the New York Fed. The lack of cash could make it harder for repo transactions to take place for financial firms facing a liquidity crunch.
• To accommodate the need for greenbacks, the Federal Reserve set up a series of USD swaps with its prominent central bank counterparts. The Fed will give the swap lines to the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. The measure should help alleviate liquidity problems abroad as banks cope with tighter financial conditions. Although this is a positive step forward, we still believe that the international banking system may be susceptible to runs in the event of a financial crisis.

The Geo-Poly Shuffle: Threats from Russia and China have forced Western countries to rethink their alliances.

• The U.S. is one step closer to removing sanctions on Venezuelan oil. The political opposition in Venezuela has discussed plans to wind down its support of Juan Guaidó’s claim of being the country’s legitimate leader. The move could pave the way for Maduro’s government to sell its crude overseas again. Venezuela has an oil production capacity of 1 mbpd. The U.S.’s decision to work with an authoritarian government suggests it feels pressure to fill the supply gap left by Russia.
• Japan and Australia will discuss improving defensive ties as they look to counter China’s influence throughout the Indo-Pacific. Beijing’s increased assertiveness over the South China Sea and Taiwan has made the partnership vital. The countries plan on sharing military intelligence and working on joint projects to build wartime technology. Tensions in the Pacific have been overshadowed by the war in Ukraine, but we believe that a conflict could break out within this region in the next five to ten years. Fighting in the area can potentially disrupt over $5.3 trillion of annual global trade. Hence, investors should be sensitive to any hostilities within the region.
• The Ukraine war continues to cause divisions within the European Union. Although the countries could agree to gas-price caps, it will not come easy. Germany, probably the most dependent on Russian energy, has decided to drop their opposition to the cap, albeit while kicking and screaming. However, the lack of unity around this issue shows that the members may not be fully cohesive in their efforts to cut themselves off entirely from Russia.

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