Could global financial conditions become too tight?

Many central banks are intervening in the currency market to defend weak currencies as well as lifting policy rates.

>> How will FED’s monetary tightening affect the USD?

They are tightening policy based almost exclusively on their reading of the domestic economic situation; particularly the rise in inflation. This has prompted some to argue that they are rather ignoring the impact that rate hikes elsewhere are having and the danger is that policy at a global level becomes too tight. While this seems a fair point there’s another angle to this debate as well; one that works through exchange rates.

Many central banks are intervening in the currency market to defend weak currencies as well as lifting policy rates. Some, such as the BoJ, are doing the former but not the latter. The result is that global foreign exchange reserves are collapsing. In the first half of the year global reserves have fallen by almost USD900bn, or nearly 7% to just over USD12tr according to IMF data. That’s far more than we have seen before over a similar period.

Furthermore, we are likely to see an even bigger fall in Q3 as we’ve already seen a record fall in Japanese reserves in September of over USD50 billion, a USD50 billion-plus fall in Swiss reserves in the same month and a South Korean fall of around USD20 billion which is the second largest ever.

Undoubtedly, some of the movement in reserves is due to valuation effects rather than intervention but it is very clear that the large bulk of the fall reflects currency intervention. But why does any of this matter?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said it matters because it tightens global monetary conditions in addition to that caused by higher policy rates, even if the intervention is sterilised, as is usually the case. It was thought some time ago that sterilised intervention has no impact on monetary conditions in an economy because the domestic currency taken from local banks, as the central banks sells foreign currency, was put back into the system by central bank open market operations.

But evidence has accumulated that periods when countries are trying to stop their currencies becoming too strong against the dollar – and accumulating reserves – have also been period in which there has been a significant increase in banks’ balance sheets. This was particularly noticeable in the decade leading up to the global financial crisis and particularly in China.

>> Why did many central banks intervene in the market?

In Mr. Steve Barrow’s view, if intervention designed to prevent local currency strength can ease domestic financial conditions, it stands to reason that intervention to produce local currency strength will tighten monetary conditions. If that’s correct, there is a growing danger that dollar strength and substantial currency intervention will serve to make global monetary conditions too tight and that’s even if the rise in policy rates by central banks does not prove excessive. Another point is that we should not ignore the bounce-back this can have on the US. Those of you with long memories will remember former Fed Chair Bernanke arguing in the mid-2000’s that excessive savings from Asia (much of which reflected surging FX reserves) were finding their way into the US treasury market and artificially lowering treasury yields. It was called his savings glut theory. Well now we have this in reverse because these ‘savings’ are coming out of the treasury market.

Last week’s data from the Fed on custody holdings showed a weekly decline in treasuries of USD42bn which is a level not seen since the scramble during the early days of Covid in 2020. Of course, there might be other investors more than willing to buy up the treasuries and other assets that central banks might be selling to fund their intervention, and do so at prevailing prices. But there’s clearly also a danger that they will only buy at lower prices and this inverse savings glut could start to produce a rise in treasury yields that exceeds the sorts of levels needed to bear down on inflationary pressure.  

“If this does not stop then our suspicion is that central banks will have to undertake coordinated action to intervene, led by the Fed, otherwise global financial conditions could become far too tight. But is this close at hand? We don’t think so; probably not before the second half of 2023 and, by then, much of the damage could have been done”, said Mr. Steve Barrow.