Central bank avalanche as FX market goes wild

As we move to the end of the week, global financial conditions have become a lot tighter. In the last two days we have seen the Federal Reserve, Bank of England, Swedish Riksbank, Norges Bank, the Swiss National Bank, and the South African Central Bank all hike interest rates between 50bps and 100bps. The outlier is the Bank of Japan, which chose to keep rates steady, however, the BOJ then had to intervene directly in the FX market to stem the yen’s decline, which is the first time they have directly intervened to strengthen their currency since 1998. As central banks are entering a game of one-upmanship to raise rates and take aggressive action to thwart inflation, it is generating uncertainty in financial markets, which in turn is causing stock and bond markets to sell off around the world, and bond yields are surging. As the US hikes interest rates at pace, this is impacting financial markets in two ways: 1, it draws money out of risky assets, which is redeployed into higher yielding US assets, and 2, it triggers other central banks to take a defensive stance and hike rates to defend their currencies. This vicious cycle has two side effects, firstly the dollar is likely to stay strong for longer, and secondly, it means that market volatility is also likely to remain elevated for some time.

The dollar and its mega uptrend

The S&P 500 closed 0.84% on Thursday, and is back in bear market territory. The Nasdaq index has sunk this week and was down another 1.37% on Thursday. This is as bad a market for tech as I have ever seen it. Every time you think that the shakeout has reached its peak there is another leg lower. While big tech has held up better than other sections of the tech market, only Microsoft and Alphabet managed to make a small gain, Amazon was down more than 1%, Apple fell 0.64%, while Tesla sunk 4%, after news broke that a massive vehicle recall was announced by US authorities. While the mega-tech stocks have beaten the overall Nasdaq index this year, as you can see, they are not immune to sell offs, and returns remain meagre and we are not going back to the heady days of 2020 or 2021. The only way to trade stocks right now is to keep to a short-term strategy, with healthcare the top performing sector in the S&P 500 on Thursday, a sign of how defensive markets have become. With a 12% return so far this year, the dollar index and cash funds are also an attractive place to hide. Bond bulls (surely there aren’t that many left, right now) were slammed on Thursday, the 2-year Treasury yield extended gains above 4%, while the 10-year yield jumped 18 basis points to 3.71%. The 2-year yield is at its highest level since before the financial crisis. While there are some who are arguing that 2-year bonds are looking well oversold and ready to be bought (yields to fall), we think that 1, the resilience of parts of the US economy, and 2, the aggressive pace of rate hikes that the Fed are committed to, means that short term yields could top 5% in the coming months. In our view, this supports a mega-uptrend for the dollar, due to the inverse correlation between the dollar and stocks, this theory of ours is bad news for stock markets for the rest of this year.

Bank of England bottles it

While we may not have agreed with the BOE’s decision to “only” hike rates by 50 basis points on Thursday, we were impressed with the 3-way split on the committee, with one member voting for a 25bp hike, 5 voting for a 50bp hike and 3 voting for a 75bp hike. Former doves have now started voting for 75 bp single rate increases, things really are changing at the BOE! However, we like the idea of intellectual diversity over group think, which could benefit the UK’s economy down the line.

However, while some people are ignoring the UK’s rate increase, thinking it is nothing to worry about, we beg to differ for a few reasons:

·      The outlook for UK rates has changed dramatically in recent months, back in August they were expected to peak at 2.75%, now they are expected to peak at 4.75%.

·      Although rates are nowhere near where they were in the 1970s and 1980s, this does not consider affordability of housing stock, which is much less affordable now, so people need to borrow more. Thus, people’s disposable incomes vs. their mortgage payments are actually similar to what householders faced in the 1970s and 1980s.

·      Thus, if interest rates do move to 4.75% or higher, some even argue that rates will need to move to 6%, then this is a big problem for householders and could precipitate a major housing crash, something we haven’t seen since the 1990s.

The economic landscape in the UK is not a pretty picture right now, while the BOE held back from a more aggressive move on Thursday, it said that “further fiscal tightening” was needed. Thus, higher rates are part of our future. There is no easy call for central banks to make right now, especially the BOE. The Bank of England only has interest rates, which have a complex transmission mechanism with the real economy, in order to bring about economic change – i.e., cause inflation to fall or to boost growth. The government has much more leverage over these matters. Thus, the BOE is in a strange tango with the government, while the energy price guarantee could keep the lid on inflation, the government’s proposed plan to scrap stamp duty and boost house prices could stoke other elements of inflation. Thus, the BOE is part one of the UK’s economic strategy, the second part is the government’s fiscal response, and we should hear more about that during Friday’s minibudget.

GBP and yields

After this week’s collapse to a near 40-year low in GBP/USD, the pound stabilised post the GBP meeting, however, it remains extremely weak, and as we mention above, if the USD is in a super cycle, then there could be further downside for GBP/USD from here. We can’t rule out $1.10 in the coming days and weeks. Elsewhere, the 10-year gilt yield had a 2-standard deviation daily move, the 2-year yield rose 14 basis points, the 10-year rose 18 basis points and the 30-year Gilt yield rose by 19 basis points. This points to a recession, the BOE thinks that we are already in one.

To conclude…

The UK wasn’t the only central bank to have a 2SD move in their bond market, so did Sweden, the US, Canada, Australia, and others. When bond yields are moving higher at this magnitude, it will be good for safe havens like the dollar, good for defensive stocks like healthcare and bad for risk overall. For now, we think this pattern will hold. When the bond market calms down, other markets will follow suit.