September 28, 2022

With inflation running rampant, central banks around the world have been tightening policy in an effort to bring it back down to more manageable levels. The Federal Reserve chairman, Jay Powell, has taken a hardline stance, saying, “we will keep at it until inflation is down to 2%. And our monetary policy tightening will be enough. It will be enough to restore price stability.” He added that these policies will cause pain to markets and economies, but that the sacrifice is worth it if it reduces inflation.

Jay Powell has previously mentioned that a prior Fed chairman, Paul Volcker, is his “idol” in terms of the legacy he wants to leave behind. To give some background, Paul Volcker was the Fed chairman from 1979 to 1987. He stepped into the position following a period of elevated and volatile inflation. In 1980, the US experienced the highest inflation rate it had seen in the modern era. In response, Paul Volcker instituted policy measures that caused the prime lending rate to exceed 21%. This resulted in a recession, but these policies did eventually bring down inflation.

When Paul Volcker instituted these policies, it was at the tail-end of an inflationary period that began in the late 1960s. By comparison, we are only about a little over a year into this current bout of inflation. Markets had a decade to adjust to the inflationary pressures by then. Markets today have only had a brief amount of time to adjust to higher inflation and subsequently tighter monetary policy.

The implications for policy continuing to tighten would be negative for markets. Yields on treasuries could rise to a range of 4.5-4.75% on the 2-year and 4.25% on the 10-year. This would imply that at the aggregate bond index level, bonds could have another 3-5% of price downside from here. The income received from bonds would mitigate some of the losses if not all of the losses depending on the speed of the increase, but it would be adding downside pressure regardless. Stocks, on the other hand, could suffer further downside of 10-20% from here based on downstream effects of further tightening occurring. This is the pain that Jay Powell talked about that investors will have to endure in order to bring down inflation.

For Jay Powell and other central bankers, this is all fine and dandy as long as the declines in asset prices continue to be orderly and nothing in the financial system breaks. If parts of the financial system start to buckle, and they likely will, central banks will have almost no choice but to reverse some of these policies. We are already seeing that with the Bank of England. The new PM, Liz Truss, announced that she aims to institute policies that are consistent with Reaganomics. This is contrary to the policies being implemented by their central bank. This slip up caused the British pound to collapse under the pressure in the last week.

UK bond yields soared in response. This has led to massive losses in UK pension plans and for other financial institutions.

Credit default swaps soared. The global market is now betting on a higher chance of the UK economy collapsing to the point where they would be unable to service their debt.

The Bank of England had no choice but to announce that they will be reversing some of their contractionary policy measures. This has resulted in the Pound stabilizing for now, but it has also caused the surge in stocks and bonds we are seeing today.

This is the dilemma central banks are facing now. There is a lot of tough talk about keeping financial conditions tight to bring down inflation, but with $50 trillion of added global debt since the last rate hiking in 2018, the global financial system is walking on a tight rope. The cracks are starting to show, and if parts of the financial system start to buckle under the pressure, central banks will have no choice but to switch from contractionary policy back to accommodative policy. If this happens, I would expect asset prices to surge. Stocks and bonds are likely to surge higher in this scenario, but I would also look to gold as it would likely be the best performer.

This isn’t happening yet, so I believe continuing to play defense is the best course of action. However, if we start to see signs of the cracks widening and central bankers beginning to falter, we may get a signal to start playing offense again.

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