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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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including new details on how Russia’s new mobilization is playing out.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a focus on the turmoil in the U.K.’s financial markets today, which prompted the Bank of England to launch a new, time-limited program of bond purchases to stabilize the markets but has added to the recent weakness in the pound.

Russia-Ukraine:  The Ukrainian military continues to push forward with its counteroffensives in the northeastern region around Kharkiv and in the south around Kherson, while Russian forces try to shore up their new defensive lines even while staging some new attacks in the Donbas region.  Meanwhile, it now appears that Russia’s new mobilization order may generate even less combat power than many observers have expected.  New reports indicate that the freshly mobilized troops, many of which have no military experience at all, are being sent to the front lines near Kharkiv and Kherson with only one day or less of training.  At the same time, Russian authorities are establishing checkpoints at Russia’s borders to forcibly mobilize Russian men who are seeking to avoid deployment by fleeing the country.  Russian officials are also setting conditions to forcibly conscript Ukrainian civilians in soon-to-be annexed areas of occupied Ukraine.

• Yesterday, Russian authorities in their occupied areas of Ukraine wrapped up their sham referendums on annexation to Russia and reported overwhelmingly positive results.  The move will allow President Putin to announce formal annexation of the areas to Russia as early as Friday.  Besides marking a political line in the sand, the move could potentially allow Russia to deploy conscripts to the occupied areas and even extend Russia’s nuclear deterrence over them, based on the argument that the areas will now officially be Russian territory.
• One little-noticed implication of Putin’s new mobilization order is that it will likely further disrupt the Russian economy.  Not only will the marshaling require huge sums to equip and pay the new troops, at a time when the Russian budget is being impacted by falling energy revenue, but it will also disrupt many businesses as workers are scooped up by the military or emigrate to avoid military service.
• On the energy front, European officials continue to investigate what caused the three leaks in the Nord Stream 1 and 2 natural gas pipelines from Russia to Western Europe.  However, Danish Prime Minister Frederiksen and NATO General Secretary Stoltenberg have both indicated it was sabotage.  Since such sabotage would most likely have come from Russia, the incident has touched off a scramble among European countries to secure their energy infrastructure.  A key target of those efforts will be the natural gas pipelines from Norway, which have now become one of Western Europe’s most important sources of gas.

United Kingdom:  Trying to calm the economic and financial market turmoil touched off by the new government’s massive tax cuts and energy subsidies, the Bank of England today said it would pause its planned sell-off of government bonds and instead purchase longer-dated gilts “on whatever scale is necessary” to restore market order.  The move comes just one day after Chancellor Kwarteng said he has been meeting with BOE Governor Baily every day to better coordinate fiscal and monetary policy.

• In the economic and financial market chaos yesterday, the 10-year gilt had sold off to yield 4.51%, and some mortgage companies suspended new fundings.  Following the BOE action today, the benchmark gilt yield has now fallen to approximately 4.00%.  The action also affected other major government bond markets.  For example, the benchmark U.S. Treasury yield had pushed to 4.017% early in the overnight trading session, marking its first foray above 4.000% in over a decade, but it fell back on the BOE news and currently stands at 3.871% as of this writing.
• One particularly disturbing development over the last couple of days has been that many British insurers and pension funds had faced big margin calls on their gilt holdings.  Those margin calls further fed the sell-off in government bonds, driving yields higher and threatening to undermine the U.K.’s financial stability.

• Since the government’s massive fiscal stimulus threatens to drive British consumer prices even higher, investors had been looking for the central bank to implement huge interest-rate hikes, bringing their benchmark rate to 6% or more in the coming months. The move to buy bonds now could potentially raise some question about the BOE’s ability to resist government pressure and to keep tightening policy over time.
• Huge interest-rate hikes that rein in inflation could well push the British economy into recession. Alternatively, if the government convinces the BOE to minimize its rate hikes, investors could start to question the central bank’s commitment to price stability.  In either case, the implication is continued depreciation of the pound.  Indeed, the pound initially rallied on today’s BOE move, but it has since turned lower again and is now down 1.5% for the day to a value of $1.0572.
• Meanwhile, the IMF issued an unusual rebuke of the tax cuts yesterday, saying, “Given elevated inflation pressures in many countries, including the U.K., we do not recommend large and untargeted fiscal packages at this juncture.” In response, supporters of Prime Minister Truss defended the move in part by stressing that the government doesn’t plan to release its spending blueprint until November.  Truss has previously said that she wouldn’t cut spending, but the statements from her supporters indicate the government plan may well go against that promise, most likely to target social spending.

Chinese Currency Markets:  Although the recent dollar appreciation has led to lower values for a range of major currencies, the pound and some others have weakened more than others.  The onshore Chinese yuan so far this morning has fallen to 7.2268 per dollar, marking its lowest level since 2008.  The yuan has now lost 13.8% of its value so far in 2022

• In response, the People’s Bank of China issued a statement saying, “The foreign exchange market is of great importance, and maintaining its stability is the top priority.”
• The central bank statement could signal that it intends to intervene in the market in the near future if the currency continues to weaken.

Chinese Politics:  Putting to rest the weekend rumors about a coup, President Xi reappeared in public leading a delegation to a major propaganda exhibition.  Even though the appearance proved Xi is still in power, and even though we still expect him to secure his precedent-breaking third term in power at the Communist Party’s 20^th National Congress next month, the coup rumors do underline that there is probably some opposition to Xi within the party.

Saudi Arabia:  Yesterday, King Salman named his son, Crown Prince Mohammed bin Salman, as prime minister, further cementing the crown prince’s power over the Saudi state.  The move was probably also meant to help rehabilitate MBS in international politics, given that he has been treated nearly as a pariah due to his role in ordering the death of a dissident journalist in 2018.

Iran:  Protests against the government’s strict morality laws and repression of women continue to expand, prompting a further crackdown from the government.  The protests and crackdowns so far have resulted in some 40 deaths, hundreds of injuries, and hundreds of arrests.  The protests have now become the largest in Iran in years, although the government’s survival does not yet appear to be threatened.

U.S. Monetary Policy:  In an online event yesterday, Minneapolis FRB President Kashkari said that the Federal Reserve must avoid repeating its mistakes of the 1970s, when it eased monetary policy too soon and allowed inflation to reaccelerate.  Rather, Kashkari warned that the central bank needs to tighten monetary policy until underlying inflation is declining and then hold policy tight until it is sure inflation is coming down.  The statement underscores how aggressively the Fed is likely to approach monetary policy in the coming months and quarters, most likely kicking the U.S. economy into recession.

U.S. Fiscal Policy:  After jettisoning Senator Joe Manchin’s proposal to ease regulations around new energy investments, last night the Senate voted to advance a stopgap appropriations bill that will avert a partial government shutdown this weekend when the fiscal year ends.  The bill now moves to final passage in the Senate and will also need approval in the House, which returns Wednesday, before going to President Biden for his signature.

U.S. Housing Market:  Illustrating how rising U.S. interest rates are weighing on the housing market, a report yesterday showed the S&P CoreLogic Case-Shiller National Home Price Index fell a seasonally adjusted 0.2% in July, marking the seasonally adjusted index’s first monthly decline in more than a decade.  The report showed home prices were still up an average of 15.8% year-over-year, but the rate of increase has been slowing, which is likely a harbinger of weaker growth in the broad economy in the coming months.

U.S. Weather Damage:  Hurricane Ian has intensified rapidly early this morning, and with sustained winds of 155 miles per hour, it is now close to the standard of 157 miles per hour needed for it to be rated a Category 5 storm.  Ian is now projected to slam into Florida’s coast around mid-day today and cause intense flooding and other damage.  If it strikes Florida as a Category 5 storm, it would be only the fifth such storm to hit the U.S. mainland.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a bit more detail on Russia’s new mobilization plan and news of a possible Russian sabotage of the natural gas pipelines to Western Europe.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  The Ukrainian counteroffensives in the northeastern area around Kharkiv and in the southern region around Kherson continue to make modest progress, while Russian forces have now succeeded in re-establishing some defensive lines and continue to stage modest attacks in the eastern Donbas region.  Russian President Putin’s mobilization order last week is likely aimed in large part at generating infantry troops with the minimal skills and equipment to defend the new Russian lines into the winter.  While that mobilization is being carried out much more broadly than advertised to the Russian people, it may take some time before significant numbers of new troops can be deployed to the battlefield.  Even then, there is some question as to how well the Kremlin can keep them supplied.  In the meantime, the domestic political costs of the mobilization are rising.  With the call-up affecting people literally across the country, protests against the mobilization are growing, at least for the time being.

• In a possible escalation of the energy war between Russia and the West, officials in Germany and Denmark reported several suspicious leaks in the Nord Stream 1 and 2 natural gas pipelines running from Russia to Western Europe. Although neither pipeline is currently operational, the officials worry that the leaks could have resulted from sabotage.
• The officials are concerned that sabotage against the pipelines could be meant as a Russian warning against a new pipeline that will bring gas from Norway to Poland. Russia might also have an interest in damaging the pipelines as a way of doubling down on its energy war with Europe, especially by signaling that Europe has no hope of renewed gas shipments through the pipelines.

European Union:  As the war in Ukraine and Russia’s cut-off of energy shipments keeps gas prices sky-high across the EU, leaders from a range of member countries petitioned the European Commission today to impose a “dynamic price cap” on gas.  The idea would be to limit prices paid to slightly above the amounts paid in other world regions in order to provide LNG shippers with a continued incentive to make deliveries to Europe.  So far, the Commission has shied away from proposing a cap, and it’s unlikely to be part of the measures put forward ahead of an emergency summit of EU energy ministers on Friday.

United Kingdom:  As the pound continued to weaken yesterday in response to government plans for potentially inflationary tax cuts, the Bank of England warned it stands ready to raise interest rates as much as needed to hit its inflation targets.  However, the central bank did not signal that it would call an interim policy meeting to consider the matter, as some investors were expecting.

• The BOE could still call an emergency meeting at any time, but if they don’t, the next regular policy meeting where the officials could hike rates would be in November.
• That means there is now the potential for weeks of uncertainty before investors know how aggressive the central bank will be in hiking interest rates. The result could well be continued volatility and downward pressure on the pound, even though the currency has rebounded modestly to approximately $1.0790 so far this morning.

China:  In updated forecasts, the World Bank predicted that China’s economic growth this year will trail that of the other developing countries of East Asia for the first time since 1990.  The institution now expects Chinese gross domestic product to grow just 2.8% in 2022, down from its forecast of 4.3% in June.  It now expects regional GDP excluding China to grow 5.3%.

• The new forecasts illustrate the slowdown China is suffering from factors like President Xi’s Zero-COVID policy, a government clampdown on the domestic real estate and technology industries, and a recent drought and heatwave.
• The Chinese economic slowdown will likely weigh on Chinese assets and further undermine the renminbi. It may also present further headwinds for global economic growth and the financial markets.

Colombia-Venezuela:  Illustrating how Colombia’s new leftist president, Gustavo Petro, is continuing to rebuild relations with Venezuela, yesterday the two countries reopened their border for the first time in seven years.  The move raises the risk that Colombia is losing its status as the U.S.’s most trusted ally in the region.

Canada:  Speaking of borders reopening, Canada’s government announced yesterday that it will no longer bar people that haven’t been fully vaccinated for COVID-19 from entering the country. It also stopped a requirement that travelers upload proof of vaccination and other information into a government app called ArriveCan.  The move will likely ease commercial and tourist traffic between the U.S. and Canada, and give a boost to cross-border trade.

U.S. Fiscal Policy:  In an estimate released yesterday, the Congressional Budget Office said President Biden’s student-loan forgiveness program would cost the federal government some $400 billion over the coming three decades.

U.S. Lumber Market:  Amid a continued slowdown in housing construction, lumber futures prices yesterday settled at $410.80 per thousand board feet, down about one-third from a year ago and more than 70% from their peak in March.  Although we remain bullish on commodities over the coming years, the pullback in lumber prices is a reminder that rising interest rates and an impending recession are likely to weigh on commodity values in the near term.

U.S. Hurricane Threat:  Hurricane Ian continues to move northward through the Caribbean, and it is now forecast to score a direct hit on Florida’s Tampa Bay later this evening or tomorrow.  Businesses in the Tampa region have closed in advance of the storm as local counties ordered evacuations for vulnerable coastal areas.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where there are many questions regarding the “partial mobilization” announced by Russian President Putin last week.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including rumors of a potential coup against Chinese President Xi and a steep drop in the value of the British pound after the tax cuts announced by the U.K. government last week.

Russia-Ukraine:  The latest battlefield reports indicate Ukraine continues to regain territory with its ongoing counteroffensives in the northeastern region around Kharkiv and in the southern region around Kherson.  However, the gains have now become more modest, and Russian forces have apparently managed to turn the Ukrainians back in some places.

• Meanwhile, protests against last week’s mobilization order continue to spread, with arson attacks against army recruitment offices now reported in at least 16 regions and protestor arrests topping 2,200. As military-age men continue to flee Russia, independent media outlets claim the Kremlin is also considering closing the country’s borders.
  • Various reports suggest the call-up is being applied much more broadly than indicated in the official announcement. For example, young men with no prior military experience have reportedly been rounded up, despite official assurances that the military would only be mobilizing reservists who had previously served in the military.
  • If the call-up is indeed much broader than advertised, it would likely generate even more pushback and further threaten President Putin politically. The Kremlin has therefore been blaming the call-up violations on over-zealous local officials.
• In another effort to find new troops, Russian military leaders in occupied areas of Ukraine are rounding up local Ukrainians and forcing them into military service against their own countrymen. As with the overly broad mobilization within Russia itself, the roundups in Ukraine are unlikely to result in new units with high morale or a dedication to the fight, even if they could be trained, equipped, and supplied quickly (which they almost certainly cannot).

United Kingdom:  Even though the government’s announcement of massive tax cuts last week pummeled the pound, Chancellor Kwarteng doubled down yesterday and said in an interview that there would be further cuts over the coming year.  With the tax cuts generating fears of out-of-control budget deficits and inflation that could further undermine the currency, investors are increasingly expecting the Bank of England to hold an emergency meeting to hike interest rates further.

• The decline in the currency continues today, with the pound sliding earlier this morning to an all-time record low of $1.0349, down some 10.9% so far this month and 23.3% year-to-date.
• In recent hours, the pound has rebounded somewhat, but it’s important to remember that Britain’s energy crisis, impending recession, and now the out-sized tax cuts are likely to continue putting downward pressure on the currency in the near term.

Germany:  As the German government desperately seeks new energy supplies to replace those shut off by Russia, it has struck a deal over the weekend for 137,000 cubic meters of liquified natural gas from the UAE to be delivered later this year.  The delivery will be the first at Germany’s new Brunsbüttel LNG import terminal, which is still being built.

• Under the deal, the UAE will send another five LNG cargoes to Germany in 2023.
• Despite the agreement, we suspect Germany will still find it difficult to meet all its energy needs over the next year or more, leading to continued high prices, economic disruption, and financial market turmoil.

Italy:  In parliamentary elections yesterday, a bloc of three right-wing parties including the neo-fascist Brothers of Italy, the League, and Forza Italia won a majority in parliament but apparently failed to win the two-thirds majority needed to push through constitutional changes.  The new government is expected to be led by Brothers of Italy leader Georgia Meloni, who would become Italy’s first female prime minister.

• Meloni has vowed to keep supporting Ukraine in its war with Russia, and to maintain Italy’s fiscal discipline in order to avoid a sell-off in the country’s bonds, although other members of her coalition will likely try to push her in the opposite direction.
• In any case, Italian stock prices and bond yields both rose modestly on the election news.

China-Coup Rumors:  Over the weekend, alternative media sources, primarily from India, were swirling with rumors of a coup against Chinese President Xi, possibly driven by Xi’s absence due to his quarantining after his trip to Uzbekistan last week.  However, mainstream media reporters said they have seen no signs of military activity or other coup signals in major Chinese cities.  With Xi preparing to take a precedent-breaking third term in office at the Communist Party’s 20^th National Congress next month, a coup in China would have major implications for global politics, economics, and financial markets.  We will continue to monitor the situation closely.

China-Currency Intervention:  Although the renminbi hasn’t depreciated nearly as steeply as the British pound, its recent weakness did prompt the People’s Bank of China to intervene today in the market by boosting reserve requirements for banks betting against the currency.  The onshore renminbi touched 7.1685 during early Asian trading hours today, hitting its lowest level since May 2020.

China-Hong Kong:  Beginning today, Hong Kong’s municipal government is ending its rule that visitors quarantine in a hotel for several days in order to stop imported COVID-19 infections.  The change marks a significant easing of one of the world’s toughest anti-pandemic regimes after more than 2½ years.

• The hotel quarantine and other anti-pandemic rules have alienated travelers, shut out tourists, and frustrated local residents, which in turn has diminished Hong Kong’s attractiveness as a world financial center. Even if the city government keeps easing its pandemic rules, it may take some time for Hong Kong to regain its past attractiveness.
• Although the government linked the eased rules to improvements in the city’s pandemic situation, the announcement came even as the municipal health authorities recorded 5,387 new coronavirus infections on Friday, including 156 imported ones, along with 12 more related fatalities. The easing of rules despite continued high infections could mean that the authorities are responding to domestic political pressure to get life back to normal.
• That could potentially be a harbinger for the mainland’s Zero-COVID policy, although we suspect any change there would be postponed until after the Communist Party’s 20^th National Congress in October.

China-United States-Solomon Islands:  In his address to the UN General Assembly on Friday, Solomon Islands Prime Minister Sogavare parroted many of China’s complaints about the behavior of the U.S. and its allies in the Indo-Pacific region, including what he called their “intimidation” after he recently signed a security pact with China.  Among other worrisome feathers, that deal gave the Chinese military the right to use Solomon Islands’ ports.

• Sogavare’s strident speech underscores how he has become a key political and military asset for Beijing in the region.
• In turn, China’s “win” in the Solomon Islands will likely exacerbate U.S.-China tensions even further.

United States-United Kingdom-Australia:  In a Friday statement marking the one-year anniversary of their AUKUS partnership, the Australian, British, and U.S. governments said that they have made “significant progress” toward Australia acquiring conventionally armed, nuclear-powered submarines.  The alliance aims to bolster Australia’s ability to defend itself and help its allies counter China’s growing military threat in the region.

• Other reports say that the Biden administration is negotiating with Australia to build its first few nuclear-powered attack submarines in the U.S.
  • That’s consistent with our view that the U.S. defense industry will initially be the main beneficiary as the world’s liberal democracies boost their defense spending in the face of greater threats from authoritarian countries like China and Russia.
  • Even though the U.S. defense industrial base has shrunk significantly since the end of the Cold War, the U.S.’s allies have let their defense industrial bases shrink even further. For the time being, at least, the U.S. industry has most of the key technology and production capacity needed to help the liberal democracies re-arm.
• The statement also said AUKUS has made “significant strides” in other areas besides submarines, including hypersonic weapons, cyber, electronic warfare capabilities, and additional undersea capabilities.

U.S. Residential Housing Market:  According to property data firm CoStar Group, asking rents at U.S. apartment complexes fell 0.1% in July, marking their first decline since December 2020.  Meanwhile, apartment-listing site Rent.com said asking rents for one-bedroom apartments fell 2.8% in the same month.  If the cooling economy and the recent apartment building spree drive rents down further, it could eventually help reduce inflation and allow the Federal Reserve to slow its interest-rate hikes.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning and buckle up! Today’s Comment will focus exclusively on the central banks. We begin with a broad overview of the latest Federal Open Market Committee (FOMC) meeting followed by an assessment of the future path of policy hikes. Next, we cover the market reaction to the Fed’s rate decision and discuss implications for the global economy. Lastly, the report summarizes how central banks responded to the Federal Reserve’s rate announcement.

It Will Be Enough: The Federal Reserve raised its benchmark interest rate by 75 bps for the third meeting in a row and signaled that it has the tools necessary to corral inflation.

• In a press conference, Fed Chair Jerome Powell reaffirmed that his position is unchanged since giving his Jackson Hole speech three weeks ago. He reiterated the central bank’s will to keep interest rates in restrictive territory until it sees compelling evidence that inflation is coming down. Although his comments were mostly hawkish, Powell signaled the Fed could slow the pace of increases at some point.
• The Fed’s latest “dot plot” shows the implied year-end fed funds rate above 4.25%. Although Powell mentioned that no decision has been made on the size of the next hike, it is widely believed the Fed will raise rates 75 bps and 50 bps, respectively, at its next two meetings. The plot also shows that policymakers favor a mild hike of 50 bps for all of next year.

• • Although there were no dissenting votes in the Fed’s rate decision, the dot plot reveals that at least one Fed member on the committee was uncomfortable lifting the fed funds rate above 4.00%. We would guess the outlier was one of the new Fed governors, either Lisa Cook or Philip Jefferson. If that is the case, future hikes could face resistance, especially if the economy falls into recession.
• The Fed’s economic projection showed that the U.S. economy could expand by only 0.2% in 2022. This tepid growth forecast suggests that central bank officials are possibly factoring in a recession later this year. Although the Fed does forecast more robust growth in 2023 and 2024, the sharp increases in the policy rate imply that the central bank does not plan to reverse course if economic growth slows.

The Markets React: Equities whipsawed, major currencies tanked, and long-duration bond prices surged as investors weighed the impact of higher interest rates on financial assets.

• The central bank has been able to raise rates because the unemployment rate remains low, but policymakers will likely not be able to sustain this pace of hikes once the economy contracts. While Powell maintains the bank plans to keep rates high for as long as it takes to bring down inflation, the central bank could face political pressure as the economy weakens and labor markets soften. For example, hours after the rate announcement, Massachusetts Senator Elizabeth Warren (D-MA) slammed the Federal Reserve for its hawkish actions for not looking out for workers. Accordingly, the recent volatility is likely attributable to investors being unsure of whether the Fed will blink when confronted with poor economic data.
• The U.S. dollar rallied against its peers following the Fed’s decision to raise rates. The euro fell further below parity, and the British pound dipped to its lowest level since 1985. The greenback’s strength will exaggerate inflation in other countries as most commodities are priced in dollars. Additionally, the currency’s strength encourages capital outflows, especially from emerging markets, as investors look to move away from risk assets into safe-haven assets. As a result, non-U.S. central banks will be forced to raise rates if they want to prevent their currencies from weakening, thus increasing the likelihood that the global economy will fall into recession.
• The yield curve inversion deepened as recession fears led to a plunge in long-duration yields and a spike in short-end yields. Because financial institutions like to borrow in the short term and lend in the long term, an inverted yield curve can hurt bank profitability. Thus, financial institutions may be less inclined to issue loans to potential borrowers. As a result, the potential decline in lending activity will hinder investment spending and may be already negatively impacting the housing market.

• • The number of existing home sales plummeted as the Fed’s interest rate hikes pushed up mortgage rates to their highest level since 2008. In his speech, Powell mentioned that he expects the housing market to enter correction territory.

The World Strikes Back: Central banks are altering their monetary policy to prevent a stronger dollar from hurting their respective economies.

• The Bank of Japan intervened in the foreign exchange market for the first time since 1998. The move was aimed at protecting the yen from depreciation, while the central bank maintained its ultra-accommodative monetary policy. The intervention pushed the dollar down 2% to around 140.2 against the yen. However, the BOJ’s action will provide limited relief for the currency as traders will still attempt to offload their yen holdings until the central bank backs away from its loose monetary policy.
  • Despite the recent central bank’s action, BOJ Governor Haruhiko Kuroda maintained there would be no change in the bank’s monetary policy.
• In contrast to the BOJ, the Bank of England lifted its benchmark rate by 50 bps to 2.25%, its seventh consecutive rate hike. The bank’s actions were relatively modest compared to the hikes of 75 bps from the Federal Reserve and European Central Bank. The BOE’s moves are likely related to confidence that the U.K. government’s plan to cap energy bills will also lower inflation. Following the hike, the pound briefly rallied above $1.13 before settling back to its 1985 lows. Although the BOE was the first major central bank to raise interest rates, we suspect it could be the first bank to pause its policy tightening as the country battles recession.
  • PM Liz Truss’s new administration has advocated for pro-growth policies as she looks to jump-start the British economy. Thus, if the bank tightens policy too much and the economy contracts, the bank will likely be blamed. This dynamic should push the British pound closer to dollar parity over the next few months.
• Several other central banks also tightened their policy to slow the rise in import prices. For example, the Swiss National Bank hiked interest rates by 75 bps, bringing the country out of negative territory for the first time since 2015. Meanwhile, the Philippines and Indonesia raised rates by 50 bps each, and Taiwan hiked interest rates by a modest 12.5 bps. Import goods, especially commodities, are primarily priced in dollars; thus, a surging greenback generally adds to inflationary pressures abroad. As a result, we suspect other central banks will continue to tighten policy until the Fed ends its hiking cycle.

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