The US Federal Reserve (Fed) believes more rate hikes are necessary to bring inflation back to tolerable levels.
However, the rapid set of rate hikes by the Fed will not only damage the US economy, just like previous rate hike cycles it will also hurt the global economy, says Hendrik Tuch, Head of Fixed Income (Netherlands) at Aegon Asset Management.
“The rising dollar ensures other countries are faced with even more inflation pressures as they pay more for dollar-denominated goods, especially commodities. Effectively, the US is now exporting globally both rising inflation and interest rate hikes, which creates problems for countries with a weak financial position and/or a weak trade balance.”
“Previous Fed tightening cycles created havoc in Emerging Market countries and this cycle will probably not be different. EM central banks in Latin America and Central Eastern Europe started last year with one of the most aggressive monetary tightening cycles in history and there is no end in sight. Not only do they need to hike more to get ahead of inflationary pressures, they also have to hike to ensure that foreign investors do not withdraw their investments in EM markets.”
Tuch continues: “Western central banks are facing similar issues now that the Fed is pulling its monetary reins. Any central bank that does not keep up with the pace of tightening as set by the Fed will see its currency weaken and its inflation outlook worsen further.”
On the euro dropping more than 10% since the start of the year Tuch comments: “We will see more weakness if the ECB sticks to a slow rate hike cycle. The European economy has already started to weaken due to the fallout of the Russian war against Ukraine and will suffer further if Russia decides to shut down its gas deliveries. Financial markets are just not convinced that the ECB is willing and able to hike the official refinancing rate considerably in the next few quarters.”
He concludes: “The previous cycle almost finished off the global banking system. In this cycle the simultaneous reduction of central bank balance sheets and a series of strong rate hikes will put pressure on all financial assets, as we have seen in the first half of the year. As long as the Fed keeps hiking and the dollar strengthens further, it will be difficult to see a durable turnaround in the current bearish market sentiment.”
