Challenging Geopolitical Backdrop

 | Oct 30, 2022 07:34AM ET

With this month's hike, the Federal Reserve would have raised overnight rates by 300 bp while doubling the pace that its balance sheet, is shrinking over the past 100 days. The US economy is the largest in the world, and US interest rates and the dollar are vital benchmarks. America's centrality remains in what has been dubbed a G-Zero world, even if its share of the world economy is a bit less than it used to be, or the dollar's share of global reserves has been eroded a bit more by the smaller currencies than the euro or yuan. So what happens in the US often has repercussions around the world.

It is striking that a little more than a year ago, US leadership was questioned over how it withdrew from Afghanistan, and parallels with Vietnam were drawn. Since then, US intelligence about Russia's intentions and plans proved spot-on, and the US has been instrumental in the Ukrainian-imposed humiliation of Moscow. Still, ironically, Putin has succeeded where American leaders have failed:  Germany and others in Europe will boost defense spending. The Nord Stream 2 pipeline, which the US long objected to, may never operate. Going forward, Europe will rely more on the US for energy and military hardware. Sweden and Finland will join NATO.

China has been weakened by Russia's invasion of Ukraine. Europe's experience over the past year makes it more suspicious of the authoritarian government in Beijing. It does not want to make the same mistake it made with Russia by thinking commercial ties can overcome political differences. US allies in the Asia Pacific region, especially Japan and Australia, have stepped up their military preparedness amid heightened fears of similarities between Russia and Ukraine and China and Taiwan. Ukraine's successfully repulsing Russian forces also offer the Taiwanese people a  powerful and positive message. And in a striking demonstration that  Russia's actions are not distracting the US from the strategic challenge posed by Beijing, new sanctions by the Biden administration threaten to seriously disrupt China's semiconductor industry.

The geopolitical backdrop is challenging, but US adversaries are largely suffering from self-inflicted wounds. And as we spend more time thinking and planning for next year, having a sense of the trajectory of the US economy, Fed policy, and interest rate is critical for businesses, households, and consumers. Unfortunately, the domestic challenges may be greater than the international ones, and the worse has yet to come.

Around the time the US withdrew from Afghanistan, the Federal Reserve pivoted and committed itself to the process of normalizing monetary policy after the Covid crisis. Between the signal and the first rate hike (March 2022), the two-year yield rose more than 125 bp, underscoring the importance of the communication channel of policy. US businesses struggled to manage inventories as the economy re-opened unevenly amid supply-chain disruptions. Who can forget the pictures of the congestion at US West Coast ports? China's zero-Covid policy led to lockdowns of key manufacturing/export areas, compounding the difficulties. Using GDP math, the trade and inventory developments saw the US economy contracted in H1. While worrisome, most seemed to recognize the quirkiness and resisted drawing the conclusion that the US was in a recession.

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The US economy bounced back in Q3, as the drag from trade in H1 22 was reversed. But surveys are picking up caution among businesses as concern about demand becomes more salient. The path to avoiding a bona fide recession looks exceptionally narrow. The federal government and the Federal Reserve are tightening policy aggressively. The fiscal headwinds are not fully appreciated, as monetary policy is often the focus. However, the US budget deficit is expected to fall from 10.8% of GDP in 2021 to 4.2% this year. After the Global Financial Crisis, achieving this magnitude of fiscal consolidation took several years.

The Federal Reserve is engaged in one of its most aggressive tightening operations, even if it was slow to begin. Moreover, the Fed continues to be surprised by the magnitude and persistence of inflation. In June, with monetary tightening well underway, the median Fed forecast was for the Fed funds to be 3.375% at the end of this year and 3.75% at the end of 2023. Three months later, the median jumped to 4.375% and 4.625%, respectively. Even this might not be enough. The futures market is closer to 4.5% at the end of this year. It sees a peak between 4.75% and 5.0% in late Q1 23 or early Q2 23. No Fed official in September anticipated a Fed funds target rate above this at the end of next year. 

There are several dimensions of the labor market. Job growth remains strong, and job openings are plentiful. The unemployment rate stood at 3.5% in September, matching the lowest since 1969. Average hourly earnings are 5% above year-ago levels, which the Fed sees as another sign of the tightness of the labor market, even though wage growth has not kept pace with inflation. A negative nonfarm payroll report would be a wake-up call. Households coping with the cost-of-living squeeze by drawing down savings and heavily using credit cards. Many had taken equity out of their homes when they refinanced mortgages, but the higher rates dried up this source. 

Financial instability can take many forms. What previously stopped the unwinding of the Fed's balance sheet was the strains in the banking system from extinguishing reserves. Around the October IMF/World Bank meetings, US Treasury Secretary Yellen expressed concern about the liquidity in the US Treasury market. To improve liquidity, the US Treasury is considering issuing extra notes and bonds and using the proceeds to buy back off-the-run issues. In late October, the German Finance Agency also addressed its liquidity challenge by increasing the amount of securities the Bundesbank can lend to traders in the repo market. 

In addition, some observers put an emphasis on the blowback from trouble abroad, such as the Bank of England stepping back into the market recently to buy bonds, the Bank of Japan's intervention in the foreign exchange market for the first time since 1998 to stop the yen from falling, and the increasing difficulty in securing dollar funding. In planning for next year, we need to recognize that the headwinds are set to intensify next year. The cumulative effect of the tighter monetary and fiscal policies has not yet worked its way through the economy. Moreover, the Federal Reserve will likely continue to raise interest rates through at least the first quarter of next year. As a result, the recession that may have been avoided in 2022 looks bound to come to the US (and Europe).

The UK has its fifth prime minister in six years since the referendum to leave the European Union. Truss's fiscal gamble was rejected by the markets and then by parliament. The old orthodoxy was restored. The tax cuts and some spending initiatives were reversed. Still, all three major rating agencies have a negative outlook for UK creditworthiness. S&P has the UK as a AA credit, while Moody's and Fitch have it as an equivalent of AA-. Sterling did not trade below $1.0920 in October after reaching $1.0350, according to Bloomberg on September 26. The UK's 30-year bond surged from around 3.5% in mid-September to above 5% and returned to below 3.50% in late October. There is no  "moron premium," as some observers have suggested. The US premium over the UK for this long maturity is back to the level seen in mid-September (~50 bp) as has the UK's 30-year premium over Germany returned to early September levels (~150 bp).

If the developments in the UK were the most dramatic last month, resulting in a new prime minister this month, then developments in China were mainly as advertised. Xi solidified his control of the Communist Party. This will translate into greater control of the state when appointments are announced in March. The iconic image of Xi's predecessor being unceremoniously escorted from the closing of the 20th Party Congress captures the moment better than the rhetoric. Xi's wing of the Communist Party appears to be fiercely nationalistically, less interested in market reforms, and undeterred in challenging the global order.