What to see from the global financial cycle?

Whatever the reason for Fed policy changes, the world can be held hostage to the bank’s monetary policy when tightening looms into view, as it is doing right now.

At its worst, Fed tightening could lead to significant global asset price weakness, particular EM strains, substantial dollar strength, commodity weakness and more. A more charitable view is that Covid-19 makes the severity of the global financial cycle less onerous than we have seen before. Which is it to be?

The idea of a global financial cycle (GFC) has been around for some time. As the authors of this paper point out there’s no particular theoretical model that describes the GFC; it’s more an observation that big financial cycles happen and that they are often created by the Fed given that the dominant role of the dollar in global trade and finance. The euro may be gaining share but the ECB’s impact on global financial conditions is said to be less than a quarter of that from the Fed. What’s more, it’s obvious to anyone who works in the financial markets that the Fed and the dollar rules the roost. There have been numerous times where changes in Fed policy have driven significant international reverberations, such as the infamous taper tantrum of 2013.

Of course, there have also been other times when exogeneous shocks have come first and initiated responses in the Fed and the dollar that have precipitated a new global financial cycle. Here we might best think about an easing of the GFC caused by the Fed’s response to the pandemic or, before that, the global financial crisis. But, whatever the reason for Fed policy changes, the world can be held hostage to the bank’s monetary policy when tightening looms into view, as it is doing right now. As this period approaches investors grow nervous. Will there be another taper tantrum for EM? Will developed countries equity markets plunge?

Against this backdrop, it is worth asking whether Covid-19 has either increased, or reduced the chances of adverse global spillovers once the Fed starts to tighten policy. To answer this, let’s think about the way in which the pandemic may have changed things. For a start, the pandemic has created much higher inflation. This may only be temporary but it means that real (inflation adjusted) rates may still remain quite low through the tightening cycle. And, as these real rates are key for asset valuations in many areas, such as equities, it could be that the pandemic actually weakens the ability of the Fed to create a destructive GFC as it tightens policy. Another point is that these inflation effects are being seen across countries and that could mean that, unlike the last tightening cycle, when the Fed took the lead, it lags behind which, in turn constrains the room for the dollar to rally.

Another issue is that the Fed continues to work hard to ease dollar shortage problems that can arise should the GFC tighten dollar liquidity. For as well as central bank swaps there are now central bank repos that allow most central banks to temporarily exchange their treasuries for cash to smooth any local dollar shortages. Putting these things together it may suggest that the global economy and its financial markets could be more resistant to tighter GFC created by the Fed.

However, there are other factors that could do the opposite. One is that the use of the dollar as the major trade invoicing currency, reserve currency, lending currency and more has not been diminished. Another is that the shock of rising inflation could force the Fed to surprise the market with its monetary policy. Should that happen, the GFC would surely tighten all the more, leading to significant economic and financial market destruction.