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Dire Consequences of Fed Inflation Moves

Dire Consequences of Fed Inflation Moves

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Concerns that the Federal Reserve’s efforts to bring inflation under control will have unforeseen and dire repercussions are rising. They have sent stocks and bonds spinning and the dollar is higher than ever, CNBC wrote in an in-depth analysis.

Perilous market phase

Over the past week, markets entered a perilous new phase, in which historically unusual moves across asset categories are becoming increasingly common. The interplay and shifts of huge global markets for bonds and currencies spell trouble according to Wall Street insiders although it’s the stock selloff that’s getting most headlines.

The US Central Bank made a series of very aggressive rate hikes after enduring criticism for being slow to recognize inflation. Its target benchmark rate is at least 3%. Benjamin Dunn, who runs consultancy Alpha Theory Advisors, commented:

The Fed is breaking things. There’s really nothing historical you can point to for what’s going on in markets today; we are seeing multiple standard deviation moves in things like the Swedish krona, in Treasuries, in oil, in silver, like every other day. These aren’t healthy moves.

The dollar surge

Market watchers have been captivated by the once-in-a-generation dollar rise. The Fed’s actions led global investors to flock to higher-yielding US assets. The ICE Dollar Index has had its best year since being created in 1985.

Two main worries

There are two main worries right now: rising volatility in traditionally safe fixed income instruments might disrupt the financial system at its core according to Mark Connors, who joined Canadian digital assets firm 3iQ in May. He is the former Credit Suisse global head of risk advisory.

The decline in Treasuries prices and ensuing higher yields could create problems for functioning of overnight funding markets as Treasuries are backed by the credit and trust of the US government.

The second concern is that markets will reveal incompetence among asset managers, hedge funds or other entities that may have taken unwise risks or been overleveraged. Forced liquidations and margin calls could lead to further market deterioration although it might be possible to contain a blow-up.

Historic similarities

Dunn, a former risk officer, likened the recent rising correlation among assets to the period right before the 2008 global downturn. Carry trades have a history of blowing up. They involve borrowing at low rates and then making investments in higher-yield instruments.

This is not the only impact of the strong dollar. It makes it harder to repay dollar-denominated bonds issued by entities outside the US, which will exert pressure on struggling emerging markets, already hit by inflation. Other countries might offload US bonds to protect their currencies, exacerbating shifts in Treasuries.

The unknown is most concerning

The unknowns are most worrying. Nobody expected a little-known pension fund trade to ignite a cascade of selling that destroyed UK bonds. However, there is reason to be optimistic. According to analysts and investors, most banks will rise to the challenge of market turmoil. Credit Suisse and other troubled European firms are an exception.

Difficulty weaning off Fed support

It is becoming obvious that it will be hard for the US and other leading economies to do without the huge support from the US Central Bank it in the past 15 years.

Peter Boockvar of Bleakley Financial Group said:

The problem with all this is that it’s their own policies that created the fragility, their own policies that created the dislocations and now we’re relying on their policies to address the dislocations. It’s all quite a messed-up world.