‘The Fed is screwing things up’ – Here’s what’s on the sidelines of Wall Street as risks rise around the world

U.S. Federal Reserve Chairman Jerome Powell during the Fed Listens event on Friday, Sept. 23, 2022, in Washington, U.S.

Al Drago | Bloomberg | Getty Images

As the Federal Reserve ramps up efforts to tame inflation, the dollar appreciates and bonds and stocks fall, concerns are mounting that the central bank’s campaign will have unintended and potentially dire consequences.

Markets have entered a dangerous new phase in the last week, where statistically unusual movements across asset classes have become commonplace. The stock selloff gets most of the headlines, but Wall Street veterans say the problem is the volatility and interaction of larger global markets for emerging currencies and bonds.

The Fed launched its most aggressive rate hikes since the 1980s after being criticized for being slow to recognize inflation. The Fed, which was close to zero in March, raised its benchmark rate to at least its 3% target. At the same time, a plan to unwind its $8.8 trillion balance sheet in a process called “quantitative tightening” or QT — which allows earnings from securities on the Fed’s books to be written off each month rather than reinvested — wiped out the largest balance sheet. buyer of Treasurys and mortgage securities from the market.

“The Fed is screwing things up,” said Benjamin Dunn, a former hedge fund chief risk officer who now runs consulting firm Alpha Theory Advisors. “There’s nothing historical that you can point to in the markets today; we’re seeing a lot of standard deviation moves in things like the Swedish krona, treasuries, oil, silver, as we do every day. These are not healthy. moves.”

Dollar alert

For now, it’s the dollar’s once-in-a-generation appreciation that has mesmerized market watchers. Global investors flocked to higher-yielding U.S. assets thanks to Fed action, and the dollar strengthened as rivals weakened, pushing the ICE Dollar Index to its best since its inception in 1985.

“This kind of strength in the U.S. dollar has historically led to some kind of financial or economic crisis,” Michael Wilson, chief equity strategist at Morgan Stanley, said in a note on Monday. According to the investment bank, the dollar’s past highs were topped by the Mexican debt crisis of the early 1990s, the U.S. tech stock bubble in the late 1990s, the 2008 financial crisis and the housing mania that preceded the 2012 sovereign debt crisis. fell on top of it.

Barclays global head of FX and emerging markets strategy Themistoklis Fiotakis said in a note on Thursday that the dollar is helping to destabilize foreign economies as it increases inflationary pressures outside the US.

He previously wrote that “the Fed is now overstretching, and that is boosting the dollar in a way that was hard for us to imagine, to say the least.” “Markets are underestimating the inflationary impact of an appreciating dollar on the rest of the world.”

Against this strong dollar backdrop, the Bank of England was forced to prop up the market for its sovereign debt on Wednesday. Investors have been dumping UK assets since last week after the anti-inflation government unveiled plans to stimulate its economy.

The UK episode, which made the Bank of England the receiver of its own debt, could be the first intervention the central bank is forced to make in the coming months.

Repo is afraid

There are two broad categories of concern right now: Increased volatility in the world’s safest fixed-income instruments could disrupt the financial system’s plumbing, according to Mark Connors, former head of global risk advisory Credit Suisse, a Canadian affiliate. digital assets firm 3iQ in May.

Because Treasuries are backed by the full faith and credit of the U.S. government and used as collateral in overnight funding markets, lower prices and resulting higher yields could prevent those markets from functioning properly, he said.

Problems in the repo market most recently occurred in September 2019, when the Fed was forced to invest billions of dollars to calm the repo market, an important short-term financing mechanism for banks, corporations and governments.

“The Fed may have to stabilize the price of Treasurys here; we’re getting close,” said Connors, a market participant for more than 30 years. “What is happening may require them to step in and provide emergency funding.”

According to Connors, doing so would likely force the Fed to prematurely end its quantitative easing program, as the Bank of England did. While that may confuse the Fed’s message that it is getting tough on inflation, the central bank will have no choice, he said.

‘Wait for the Tsunami’

A second concern is that whiplash markets will expose weak hands among asset managers, hedge funds or other players who have overloaded or taken unwise risks. While a blowout can be avoided, margin calls and forced liquidations could further shake markets.

“When the dollar appreciates, expect a tsunami,” Connors said. “Money floods one area and leaves other assets; there’s a ripple effect.”

The growing correlation between assets in recent weeks reminds Dunn, the former risk officer, of the period before the 2008 financial crisis when currency bets collapsed, he said. Carry trading, which involves borrowing money at low interest rates and reinvesting it in higher-yielding instruments, often with the help of leverage, has a booming history.

“The Fed and all the central bank actions are setting the stage for a pretty significant move right now,” Dunn said.

A strong dollar has other effects: It makes it harder to buy back dollar-denominated bonds issued by non-U.S. players, which could put pressure on emerging markets already struggling with inflation. And other nations may load up on U.S. securities to defend their currencies, fueling moves in Treasurys.

The so-called zombie companies that have managed to survive the low interest rate environment of the past 15 years are likely to face a “calculation” of defaults as they struggle to pay down more expensive debt, according to Tim Wessel, a strategist at Deutsche Bank.

Wessel, a former New York Fed employee, said he believes the Fed will need to end the QT program. That could happen if funding rates rise while the banking industry’s reserves shrink too much for the regulator’s comfort, he said.

Fear of the unknown

Wessel says it’s the unknowns that are most intriguing, just as no one yet expects an unknown pension fund trade to ignite a cascade of sales in those cratered British bonds. The Fed is “learning in real time” how markets will react as it tries to rein in the support it has provided since the 2008 crisis, he said.

“The real concern is that you don’t know where to look for those risks,” Wessel said. “That’s one of the things about tightening financial conditions; people who are overextended end up paying the price.”

Ironically, it is the reforms emerging from the recent global crisis that have made markets more fragile. After U.S. regulators forced banks to pull back from private trading activities, trading across asset classes is thinner and easier to disrupt, a dynamic JPMorgan Chase CEO Jamie Dimon has repeatedly warned against.

Regulators did this because banks took too much risk before the 2008 crisis and assumed they would eventually be bailed out. While the reforms shifted risk away from banks, which are safer today, they forced central banks to shoulder more of the burden of keeping markets afloat.

With the exception of troubled European firms such as Credit Suisse, investors and analysts said most banks were confident they could weather the market turmoil ahead.

What seems clearer, however, is that it will be difficult for the US and other major economies to end the Fed’s extraordinary support over the past 15 years. It’s a world that Allianz economic adviser Mohamed El-Erian derisively calls “la-la land” of central bank influence.

“The problem with all of this is that it’s their own policies that create the fragility, their own policies that create the dislocations, and now we’re relying on their policies to fix the dislocations,” said Peter Boockvar of Bleakley Financial Group. “It’s all quite a messed up world.”

Fix: A previous version misstated the quantitative compression process.

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