Could the tightening of policies slow down?

Minneapolis Fed President Kashkari said that the stock markets’ value is not a goal for the Fed.

>> How will FED deal with risk of recession?

It has been a miserable year so far for bonds and stocks. The Bloomberg aggregate investment grade bond index is down some 12.5% in dollar terms, while the MSCI global measure of stocks is down by nearly 15%. There are no signs that these sorts of declines are affecting the thinking of policymakers as they chase inflation with more and faster rate hikes. But could they become concerned? And could policy tightening slow down in response?

As many have argued before him, Minneapolis Fed President Kashkari said that the stock markets’ value is not a goal for the Fed. Many might dispute this, as the Fed’s rate-cut safety net often seems to have come out when equities are plunging. That’s understandable if plunging stocks are indicative of a sharp rise in economic risk, as it was, for instance, during the pandemic or the global financial crisis.

Economic risks are undoubtedly rising now, but the difference, of course, is that many of these are borne of inflation, not deflation, and that would seem to rule out the deployment of the Fed’s safety net this time. Without the safety net of policy easing, it seems that stocks and bonds are in significant peril, even after the drubbing we’ve seen so far this year.

For it is not as if the factors causing tensions, such as the conflict in Ukraine or China's zero COVID policy, are close to being resolved.All the while, as inflation pushes higher, so increased inflation expectations embed themselves in the nations’ psyche, implying much more tightening to come from G10 central banks.

But is there not a stage where things get so bad that they actually become good for risk assets because central banks are forced to scale back or even reverse their rate hikes?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, doubts it just on the basis of the extent of weakness in these asset prices, but if their decline comes in conjunction with severe financial stress, it might be a different matter. The US Treasury breaks down global financial stress according to whether it comes from factors such as equity valuation and volatility that we’ve already mentioned, but also things like credit strains, funding stress, and safe-asset demand.

So far, and unsurprisingly, it seems that the rise in financial stress we have seen since Russia invaded Ukraine in late February has come from the slump in equities and the rise in volatility. In other words, from the stress indicators that we think the Fed is likely to care less about. In contrast, stress indicators such as credit, funding, and the demand for safe assets still sit below the zero line on the Treasury’s measure, suggesting that they are not, as yet, "stressed."

>> Policymakers face a difficult decision

However, indicators of stress in credit and funding have been moving higher, although safe-assets have not, which is probably a function of the fact that treasury prices are sliding in response to high inflation rather than falling because of safe-haven demand. What all this shows is that, so far, there has not been a major spillover from the stress indicators the Fed may be less concerned about (equity valuations and volatility) to the ones that could possibly provoke a rate-hike pause (credit, funding, and safe assets). A key issue is whether these more important stress indicators will begin to surge if asset prices like equities and bonds continue to slide, and particularly if they go into freefall.

Mr. Steve Barrow suspects that stress indicators will fall much further. But given the extent of inflation right now, just how much financial stress would we have to see for the Fed and other central banks to pause on rates or even reverse course? "The answer could be "a lot" and we, for one, remain sceptical that what might ultimately come to the rescue of bonds and stocks in the long term is a financial meltdown now that provokes the Fed to change course. A corollary to this is that the dollar’s value is positively correlated with the financial stress index, and, as long as this index rises—but does not provoke a Fed policy re-think—the dollar should continue to appreciate", Mr. Steve Barrow said.