Can the US economy and financial market sustain the recent explosive interest rate hikes?

 

The recent explosive interest rate hike from zero to 3.75% federal fund rate has caused most of the asset classes to collapse. Stocks, bonds, crypto and real estate have all been hit hard, resulting in bear market following unprecedented rally in all asset classes back in 2021.

 

Many predict economic recession is looming in 2023, and fear that further interest rate hike followed by persistent inflation will cause further pain ahead.

 

However, interest rate is most likely to not pass the current consensus, which is at around 5% federal fund rate by 2023 for the following reasons.

 

1. Signs of slowing CPI

 

The consumer price index (CPI), a key inflation barometer, jumped 7.7% in October versus a year ago, which was lower than the consensus of 7.9%. It rose 0.4% during the month.

 

Although the absolute number of 7.7% in October 2022 looks still high, the important takeaway is that the trend shows the downward direction following the peak of 9.1% in June 2022.

US Consumer Price Index 2022

Source: Investing.com

 

It usually takes more than 6 months for interest rate hike to take effect, as there is a policy lag to real impact on the economy. The Fed started interest rate hike starting from 2022 March, and it seems that the real impact is crystallizing, gradually.

 

 

2. Japan’s shorting of US treasury

 

On the contrary to the rest of the world following the interest rate hike, Bank of Japan has been maintaining virtually zero interest rate for the last decades.

 

As the foreign exchange rate theory of economics indicates, money moves from the lower interest rate country to the higher interest rate country, causing depreciation of the currency in the lower interest rate country. The below chart shows how much JPY depreciated against USD in 2022.

USD/JPY exchange rate 2022

Source: Investing.com

 

What does Japan have to do with US interest rate hike?

 

As Japanese yen depreciates against US dollar, it creates an enormous pressure for Bank of Japan and Japanese government to maintain stable exchange rate. Gone are the days when exporting companies benefit from weaker currency, as strong USD is causing inflationary pressure in Japan and puts burden on Japanese consumers.

 

Why does Bank of Japan and Japanese government cannot raise its central interest rate? This will be discussed in subsequent articles.

 

Instead of raising interest rate, they are using their foreign exchange reserve to ease the strong USD by selling their USD into exchange rate market. This is temporary solution, however, as they have a limited foreign reserve and cannot continue to sell USD beyond what they have.

 

Hence, Japan has been shorting US treasury to get their USD back to their reserve, which creates another pressure on US treasury to drop in value and rise in yield (Japan is the second largest US treasury holder next to China. I will write about this in subsequent article as well).

 

Can US continue its interest rate hike without regards to other countries? Most likely not, as the US financial market is closely intermingled and connected with the rest of the world.

 

In short,

  • Interest rate hike in US leads to depreciation of JPY against USD
  • Japan needs to maintain its foreign exchange rate, and hence, sell US treasury to get USD
  • This creates another pressure on US treasury market, causing yield to rise and price to drop

 

3. Financial turmoil

 

Rise in interest rate inevitably entails pain for investors in financial market. If it can be done smoothly, then economy can go back to cycle without causing a collapse in the entire system.

 

However, if not, then the entire financial market and economy suffer from crisis, as we have witnessed in 1997 Asian financial crisis and 2008 global financial crisis.

 

In England, there was a Gilt crisis, which was caused by rise in the yield rate followed by the new tax overhaul. It did not materialize as full-blown crisis as Bank of England stepped in to stabilize the bond market.

 

As ominous signs of troubles start to show up, the Fed may not want to risk further de-stabilizing markets by venturing to further interest rate hikes.

 

Conclusion

 

The cooling of interest rate hike will depend on various other factors as well, such as Russo-Ukraine war, recovery of global supply chain from the COVID-19 pandemic, Chinese zero-covid policy and etc.

 

However, at this current stage, raising further interest rate would do more harm than reigning in the inflation rate.

 

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