Markets capitulate as the Fed overcooks it

  • The Fed was “temporary” on inflation and is now “permanent” on inflation
  • Japanese Yen FX Market Interventions, Will Others Follow?
  • NZ monetary policy not as tight as needed
  • Why the NZ Dollar sold further down than the AUD and EUR

The Fed was “temporary” on inflation and is now “permanent” on inflation

Another tumble in US stocks on Friday 23rd September and a further rise in the value of the US dollar against all currencies underscores just how much the ‘fear’ factor has increased among investors since the US Federal Reserve’s stubborn monetary tightening redone 2 days earlier. Investors are now much more fearful of a US and global recession. The longer the Fed sticks to its line, the greater the risks of an unnecessary economic recession. The collapse of all major currencies against the USD is reminiscent of the March-May 2020 panic period when the pandemic shock hit and the world ran out of US dollars. The Fed was then forced by global events to change its stance and may be forced to do so again. The Kiwi-dollar made a spectacular bounce back from the 0.5700 level 30 months ago and is about to do the same again as the Fed is forced to retreat.

A year ago, the US Federal Reserve was heavily criticized for making a policy mistake by believing for far too long that the rise in inflation at the time was only ‘temporary’ (ie temporary) and nothing to worry about. The inflationary pressures came from their own policy of 0% interest rates and money printing about 12 months earlier. As it turns out, they hiked rates too late in late 2021 and early this year. Now that they are well past the monetary tightening cycle, they appear to be running a high risk of making another policy mistake by tightening too far (ie, boiling them over) just when inflation is showing clear signs that they are slowing down rotates below. You risk throwing the economy into an unnecessary recession. Fed Chair Jerome Powell mentioned at last week’s FOMC meeting that gasoline prices are now declining and housing indicators are pointing to a sharp slowdown. However, his message, and the accompanying “dot-plot” interest rate forecasts, was that interest rates would need to go higher and stay higher for some time to bring inflation down. It appears the Fed will need to see the unemployment rate rise and job vacancies fall significantly before believing inflationary risks have abated. By then, the US economy could already be in deep trouble.

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There’s a good chance they’ll realize too late that they’re wrong again!

We remain of the view that the energy, food and rental components of US CPI inflation will fall at the rate they rose in the first six months of 2022 over the coming months. The Fed will be forced to turn around to reverse the trend USD fortunes could materialize much sooner than current market prices suggest.

Japanese Yen FX Market Interventions, Will Others Follow?

Japan’s monetary authorities have threatened markets to intervene directly in FX markets to stop the ‘unilateral’ devaluation of the yen. They made good on their threat of action last week taking the JPY/USD back to 141 from above 146. Significantly higher US interest rates and the value of the USD will severely damage the emerging markets, whose debts will have to be serviced and repaid in US dollars. The British and Europeans cannot be satisfied with this recent currency depreciation raising their already higher inflation rates. Older FX market participants will remember the central banks’ joint market intervention in the 1985 Plaza Accord to halt US dollar strength. They did the same thing in the mid-1990s with the Mexican peso crisis. Pressure is building for the Fed to consider the impact of an overvalued USD on the global economy, another variable forcing it to focus on monetary policy sooner rather than later.

NZ monetary policy not as tight as needed

In its last policy statement in August, the RBNZ considered a stable TWI currency reading of 71.7 for its inflation and economic forecast horizon over the next three years. Since then, the NZ Dollar has sold off more than many other currencies against the unbridled US Dollar in the global currency markets. The two prominent examples that show this are the sharp depreciation of the NZD/AUD cross rate from 0.9000 to 0.8800 and the NZD/EUR cross rate which fell from 0.6200 to 0.5900. As a result of the NZ Dollar’s underperformance, the NZ Trade Weighted Index (TWI) fell to 68.8 on 23rd September. The 4.0% TWI depreciation since early August and the even larger 10.8% depreciation in the NZD/USD exchange rate over the same period (0.6450 to 0.5750) has effectively eased monetary conditions in the economy.

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The TWI at 68.8 is approaching the previous record low observed in March 2020 when the world was tight on USD at the onset of the Covid shock and in 2015 when milk prices collapsed (see chart below). The consolation for our exporters, who currently have FX forward hedged positions well above current spot exchange rates, is that these two prior TWI index down spikes were followed by an equal reversal to the upside over the following 12 months .

The looser monetary conditions from the lower exchange rate mechanism are the opposite of what the RBNZ wants at this point. Exchange rate depreciation is driving up import costs and hence consumer goods (including food) inflation. Therefore, in its next report on October 5th, the RBNZ will have to raise its inflation forecast for June 2023 from the current annual rate of 4.50% to slightly above that to reflect the much lower exchange rate.

The RBNZ cannot simply dismiss the currency depreciation as being caused by the rise in US interest rates to the level of New Zealand interest rates and therefore having nothing to do with it. Their mandate is to bring inflation back below 3.0% so they need to take additional monetary tightening action on interest rates to stop the rot with NZD depreciation.

Why the NZ Dollar sold further down than the AUD and EUR

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In our midweek update comment for our clients last week, we listed a number of factors behind the NZD’s underperformance versus the USD versus the AUD and EUR. The NZD was picked for stronger selling for the following reasons:-

  • Lower global growth forecasts for 2023. The kiwi shows some correlation to global GDP growth.
  • Much lower GDP growth than Australia last year (+0.40% vs. +3.30%).
  • Rising overseas trade deficits as export volumes are hampered by labor shortages.
  • The Ardern proclamation government has no new economic policy initiatives.
  • NZ listed higher yielding dividend stocks that are no longer attractive to offshore investors as interest rates rise globally.
  • The rest of the world perceives that the Hermit Kingdom is not yet open again for business, investment, immigration and tourism (despite what Jacinda says!).
  • The Ardern announcement government has further alienated itself from the business community as the NZ Herald “atmosphere in the meeting room‘ Confirmed last week.

An additional source of NZD selling activity has emerged in recent months in the form of the NZ Super Fund, which has been forced to reduce its NZD FX hedging on its NZD 57 billion investment portfolio, the majority of which is invested in international equities and bonds is. The Super Fund operates a 100% currency hedging policy back to NZD on both global equities and bonds (most local fund managers leave equities unhedged but have bonds 100% hedged). Therefore, if the value of their offshore investments falls by $3.3 billion (as has been the case in recent months), they will need to reduce their NZD bought/USD hedge amount sold by selling the NZD. If the shares eventually bounce back, the Super Fund will increase its hedge amount to make up for it by being a buyer of NZD.

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*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has been writing commentary on the NZ dollar since 1981.

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