FX: What happens when a tightening cycle ends before inflation is defeated

The central bank tightening cycle has effectively already reversed as a function of lower forward expectations. That cycle came to an end on the sudden meltdown and official intervention over two consecutive weekends to avoid systemic risks stemming from failed or failing banks, in the case of Silicon Valley Bank and Credit Suisse, respectively. These situations arrived with such speed and impact that we have seen some of the most violent moves in US interest rates at the short end of the yield curve in market memory. Indeed, the central bank tightening cycle finally “broke something”. Unfortunately for policymakers, that something was pockets of the banking system rather than inflation. While bank funding challenges are likely to bring the recession forward, inflation will likely bottom at a very high level, presenting the worst possible policy challenge for central banks.

With perfect hindsight, the tightening cycle that kicked off in late 2021, but really didn’t accelerate until the summer of last year, was too much, too fast for the weakest links in the global financial system, even if the real economy was weathering the policy headwinds very well (as well as a number of emergency support measures, especially in Europe, that helped sustain inflation levels). But these new cracks in the system come at an awkward time for central banks, who are far from putting the inflation genie back in the bottle. Economies continue to absorb the monetary and fiscal policy excesses brought about by the pandemic, and new industrial policy and national security spending imperatives brought on by the Fragmentation Game that is the underlying theme of this Outlook risk aggravating inflation further from here. As fiscal austerity is out the window, not only on those imperatives, but also due to automatic CPI indexing of social transfer payments, inflation has sustainably reset to a higher, if probably far more volatile, level.

While a cessation of central bank policy tightening may be upon us, we’re not likely to see the kind of across-the-board celebration in risky assets that prior easing cycles have brought. First, sticky inflation will likely make it difficult for central banks to ease on anything close to the scale of previous cycles once we do get to an actual policy easing. Second, the market realisation that central banks will fail to get ahead of inflation and the ensuing setting of long-term inflation expectations higher will likely mean that long yields remain pinned at uncomfortably high levels, even if the economy begins slowing due to a credit crunch. It’s the worst of all worlds for central banks, which will be caught between the rock of inflation and the hard place of governments needing to continue to support the economy with deep-deficit fiscal spending. What do they do?

They all turn to the Japanese playbook in the end

Let’s consider the next slowdown, possibly brought about by a weakening credit cycle, but with funding expensive because of still-high inflation: eventually too expensive for governments to issue the scale of debt they will require for spending needs without destabilising bond markets. (Think Truss-Kwarteng bond response writ large). In any crisis, the sovereign must be funded, so the sovereign will be funded. And if bond markets ring the alarm bell, central banks must swing into action and will ultimately implement Bank of Japan-style yield curve control (YCC) on bond markets as they are reduced to mere accessories, or even enablers of the sovereign. The move may not be explicit at first, but it will be de facto. And it means we are now crossing the threshold into this new era in which central banks have lost their independence.

The yield levels in a new YCC regime won’t be anything like the BoJ’s -0.10% and 10-year cap of 0.50% (up from the 0.25% of the prior several years) but far, far higher. But they will still always be somewhere below the average inflation level, whether that means a policy rate of 3 and inflation of 6, or 4 and 7, or even 2 and 4, respectively. All sovereign governments need to deleverage either themselves (US, UK, parts of Europe, Japan) or their economies (everyone else in this bucket) or both (France!) and the only way to do so is via default (unacceptable), an enormous growth bonanza (impossible), or devaluation of debt through inflation (bingo).

In other words, we can never expect that central banks will manage to hike policy rates into meaningful positive territory nor tolerate the spending and nominal growth speed-limiters of high long rates. That spells an eventual yield curve control to both keep the fiscal side funded, and keep real rates negative. Negative real rates of negative two to three percent over a couple of decades can reset debt to sustainable levels. The game for currency investors will be to determine which currencies are likely to offer the least bad negative real rates and which assets can maintain the highest real returns (hard assets and companies that can raise prices at inflation or better) and which economies offer the most of these assets in a world engaging in the Fragmentation Game.

Chart: JPY on the road to recovery?

Q2 sees the dawn of a new era for the Japanese yen, and not just because Bank of Japan governor Haruhiko Kuroda is set to leave in April after ten years at the helm, but also as we are likely on the road to other central banks shifting, by necessity, to mimicking Bank of Japan policy, even if at different nominal yield levels. If so, this could help take the pressure off the JPY to some degree if lower and even negative long-term real (not nominal!) yield expectations become more embedded everywhere as we expect will be the case. Japanese investors may repatriate a portion of their immense savings if real yields elsewhere are unsatisfactory. This could allow a significant repricing of the broader JPY higher over the next couple of years, perhaps 10-15% in the CPI-adjusted Japanese yen real-effective rate index shown below.