Tightening Cycle

Posted By Darren Winters on Jul 27, 2023

Tightening Cycle

Fed tightening cycle could be maturing, and the engineered recovery in financial assets may be allowed to continue making a soft landing possible. 

The Fed is in the cockpit of a metaphorical jumbo plane, navigating global financial markets, the global economy mindful to fly clear from the coffin corner.

A too-high altitude, red hot economy, raging bull market with runaway inflation, and the jumbo loses control and crashlands.

If the Fed flies too low, in an attempt to control inflation, by allowing the economy and markets to nose-dive, there is a greater risk of collision with the terrain. A crash landing great depression scenario would be where financial markets and the economy enter an uncontrollable tailspin. 

Soft landing, with the nose up, is where restrictive monetary policy is implemented for longer to dampen demand and inflation while recovery on financial markets is allowed to continue. 

However, the problem with the soft landing view is it assumes inflation is demand-driven. What if inflation is cost-driven due to rising input costs of energy and other vital commodities?

The Ukrainian War, the worst war this century, is causing global inflation, rising input costs, shortages as supply routes are disrupted, and war materials compete for resources.   

If the battlefield spreads to the Baltic Sea, and transport ships are destroyed, that would be inflationary.  

The outcome of the Ukraine war impacts the trajectory of Fed tightening cycle  

Tightening Cycle

For the above geopolitical reason, a bet that the Fed’s tightening cycle is maturing is a high risk unless you have ahead up on foreign policy. The wild card is the conclusion to the Ukraine war. Ukrian’s counteroffensive has failed. If you are an optimist, this means the war has ended. But the military build-up in Poland over the past year indicates the US and its allies could be gearing up for the mother of all wars with Russia, something unthinkable a few years ago.   

The Fed’s tightening cycle has been spectacular, 525 basis points over 12 months, and market players and the Fed know this is restrictive

The domestic and global economy is in freefall by whatever matrix. Germany is knee deep into a recession as its manufacturing collapsed under the weight of high energy costs as the German PMI nosedives to 46 Great Depression levels. Over the English Channel, the UK economy is paralysed by inflation and high-interest rates. Investors are steering clear of gilts as UK government borrowing costs go sky-high. 

In the US, restrictive Fed tightening policy and macro trends could make commercial real estate the subprime of 2023. The Fed’s Overnight Reverse Repurchase Agreement, emergency day-to-day liquidity to keep banks afloat, has come down since the banking crisis but remains high 

Fed’s tightening cycle; from such a low altitude, the Fed sees from the cockpit window calamity on the ground.

The latest FOMC meeting 11 rate hikes 25 basis points to a target range of 5.25% to 5.5% indicates that the Fed’s tightening cycle is maturing

Rising unemployment is what the Fed wants to see to crush demand, keeping prices down, and they could get more than what they hope for.  

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