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Tuesday, August 23, 2022
Inflation: Source of Volatility in Global Capital Markets
Wei Hongxu

On August 22, after a round of rebounds, U.S. stocks experienced another volatility correction. The Dow fell 1.91%; the Nasdaq dropped 2.55%; the S&P 500 saw a decrease of 2.14%. In Europe, Germany's DAX30 fell 2.33%, Britain's FTSE 100 dropped 0.21%, and France's CAC 40 too, fell 1.8%. On the next day, the Asia-Pacific markets were also sluggish, with both Japan and South Korea stock indexes falling. Nikkei 225 closed down 1.19%, South Korea's KOSPI index fell 1.10%, and Hong Kong's Hang Seng Index fell 0.78%. At the same time, in the foreign exchange market, after the U.S. dollar index rose to a high of 109, major currencies such as the euro and the yen fell once more. The turmoil in the capital market this time is even more worrying than what happened previously. With the Federal Reserve continuing to raise interest rates, and as the U.S. economic growth decelerates, the global capital market will descend into turbulence.

After the Fed continued to hike interest rates in July, it did not cause fluctuations in the capital market. On the contrary, since mid-June, due to the expectation of peaking inflation, U.S. stocks have rebounded strongly. The dollar index has fallen, and U.S. bond yields have also dropped correspondently. This situation is the result of the balancing of the market and the Fed's policy. The market is more inclined to reduce inflation due to the deceleration of the U.S. economy, which in turn will cause the pace of the Fed's tightening policy to slow down. As a result, bad news for the economy has turned into good news for the capital market, bringing about a "misalignment" between policy and market behavior. In addition, investors' zeal for a "recession deal" is effectively underestimating the policy risks posed by U.S. inflation and a slowing economy.

The reason why the market believes that the Fed will slow down the pace of interest rate hikes is that it still expects the Fed to consider the impact of the slowdown in the U.S. economy and employment situation. This has happened many times during Jerome Powell's tenure at the Fed. Unlike the Fed's previous worries about employment and economic recovery, in order to maintain the credibility of the central bank and mend the impact of the previous policy lag, the Fed is faced with the dilemma of inflation and economic downturn. In the end, it prefers to give priority to solving the inflation problem. Some Fed officials have recently repeatedly emphasized the Fed's determination to deal with inflation and warned that although inflation in the U.S. begins to dip, it will remain high. This also means that the Fed's rate hike cycle will be longer than expected. After the Fed's policy decision was disclosed, it expressed its attitude of continuing to raise interest rates to deal with inflation.

Judging from the recent messages of the Fed, the pressure on the supply side such as geopolitical risks, supply chain problems, and energy issues still exists. Hence, the inflation problem will not just go away quickly in the short term. This means that although the Fed will consider the consequences of the U.S. economy heading for recession, the threat of inflation is more immediate now, and the long-term impact of it on the economy and capital markets is more pronounced. This is also the reason why it still insists on tightening policies for a considerable period of time. The influence of the capital market itself, after experiencing volatility in the first half of the year, has become comparatively less significant in the Fed's policy decisions. This causes the capital market to begin reassessing the Fed's policy direction and inflation trends, and change its strategy of betting on policy transactions for arbitrage. According to researchers at ANBOUND, the increasingly significant impact of inflation is the root cause of this round of capital market corrections.

The policy and economic changes caused by the inflation problem have not only brought about fundamental troubles to the American capital market, especially the equity market, but also to the major global capital markets as well. As far as the global situation is concerned, major economies such as Europe and Japan are also in the predicament of high inflation and economic downturn, and their risk of an economic recession is greater. At the same time, they also need to face the policy differences caused by the Fed's tightening policy impact on the respective currencies. The continued decline of the euro and the yen will be further deepened as the Fed continues to raise interest rates, which will also lead to further volatility in their respective capital markets. Emerging markets, including China, are facing more difficulties in withstanding the impact of the Fed's policy shift. Goldman Sachs recently stated that there are two main factors driving the recent rebound in risk asset markets. The first is investor optimism and the second is expectations for a more dovish monetary policy. According to Goldman Sachs, as the risk of recession has not completely subsided, and inflation is still likely to remain high for a long time to come, the decline in risk assets globally, especially in the U.S., is far from over.

The reason why market institutions pay special attention to the speech of Fed Chair Powell at the annual central bank gathering is not only concerned with the leading role of the Fed in global monetary policy but more importantly, it is also with the hope to obtain information on the trend of the monetary policy to so that plans can be formulated in advance. In the current situation where U.S. inflation is difficult to fall in the short term, changes in the pace of interest rate hikes in the short term will not actually change the Fed's policy tightening cycle. Against this backdrop, a slowdown in the U.S. economy would be expected, but this will not be a priority for the Fed. The balancing act between the capital market and the Fed's policy is likely to have to change as inflation continues.

Final analysis conclusion:

Fluctuations in U.S. stocks and global capital markets, as well as the depreciation of major currencies, all signify that capital markets are adjusting their expectations for the Federal Reserve's policy trend. With inflation becoming increasingly prominent, this will not only be the main consideration for the Fed's continued tightening of policy, but also a major factor affecting the direction of global capital markets.

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