How will FED's tightening cycle impact USD and risk assets?

Last week, S&P 500 fell 0.4% to 4,677.03, losing 1.9% in the first trading week of 2022. The Dow Jones finished marginally lower at 36,231.66.

The US dollar is more likely to slide and risk assets rally when the Fed is in tightening mode, while dollar strength and risk asset weakness are things that are more common when the Fed is easing, particularly if it is slashing rates or conducting QE in the midst of a crisis such as COVID-19 or the global financial crisis. But before anybody gets too enthused about the prospects for dollar weakness or asset price strength, it is worth bearing in mind that this tightening cycle could be unlike any that we’ve experienced for many decades.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy argued not so long ago that this observation about the movement of the US dollar and risk assets when the Fed is tightening comes about because there are two elements to the Fed’s actions. The first is that rate hikes and/or quantitative tightening usually cause US rate differentials to rise, exerting upward pressure on the dollar while the rise in the riskfree rate pressurises stocks. If this were the only effect, we might expect to see the dollar rise and equity prices fall. But it is not. There is also an "information" component, and usually this ‘information’ is that the US economy is performing strongly, thus justifying the rise in rates. This "information" effect seems to outmuscle the rate effect as investors increase exposure to riskier assets (stocks and non-dollar currencies) in anticipation that the good "information" news from US rate hikes will outweigh the bad news from the rate hike itself. This also holds true in reverse, as Fed rate cuts cannot, at least initially, outweigh the bad news that comes with a pandemic or a financial crisis.long as Fed rate hikes convey enough positivity about the US economic outlook, the FX and equity markets will overlook the negative effects of higher rates and, as a result, the dollar will fall and risk assets will rise", Mr.Steve Barrow said.

But if the ‘information’ effect from Fed tightening conveys bad news as well, That’s what could be happening now as the Fed’s primary justification for its hawkish message is rising inflation; something that we have not encountered since the 1970s and early 1980s. Soaring inflation is undoubtedly bad news because it does things like reduce households’ real income and damage budgets as governments are forced to increase expenditures. Hence, if the ‘information’ effect is negative, it will combine with the negative effects of the rate hikes to create a double whammy for risk assets.

In other words, the ‘positive’ history of Fed tightening cycles in the recent past is not applicable now, and we should, instead, be geared for a stronger dollar and weaker risk assets as the Fed lifts rates. So, the big question for investors right now is as follows: will this be a ‘good’ tightening cycle where positive information effects outweigh higher rates, or a "bad" tightening cycle where negative information effects combine with higher rates to hit currencies and stocks hard?

For the moment, Mr.Steve Barrow said that the risks would be skewed to the latter, meaning that the dollar is more likely to rise and risk assets falter. What investors need to see for this negative scenario to turn into a positive one is a moderation of inflationary pressure. On this note, there are some tentative signs of easing pressure, such as those seen in PMI surveys, and annual inflation will undoubtedly be helped by high base effects from last year. But it is whether these things can collapse price pressures in the way the Fed thinks, with PCE inflation, for instance, falling to 2.6% this year from 5.3% in 2021 (according to the median FOMC forecast). "We remain sceptical about this and would advise investors to trade the early part of the year with a bias towards a stronger dollar and weakness in risk assets,", Mr.Steve Barrow recommended.