Case for rally in risk assets

By Matein Khalid
The financial markets gave a green light to risk assets after the December FOMC conclave because the Federal Reserve has shifted its monetary strategy from post pandemic money printing to a traditional anti-inflation stance. Chairman Powell’s decision to drop his “inflation is transitory” argument and the FOMC’s decision to double the taper with three planned rate hikes in 2022 is thus a game changer in global capital markets.

The dramatic plunge in the Volatility Index after the FOMC move means that a Santa Claus rally in risk assets began last night and will continue on Thursday.

Dr. Fauci’s call that there is no need for a variant specific vaccine booster also reinforces the case for a rally in risk assets and specific reopening stocks hit hard in the past three weeks.

Economic history is replete with Fed policy failures/misjudgments that led to a hard landing. This is entirely possible in 2022 given the sheer scale of bubbles in the credit markets and the black swan DNA of a global killer virus amid a new Cold War with Russia and China.

The Fed’s anti-inflation pivot can also be derailed by a democratic parties, fiscal extravagance even though President Biden’s reappointment of Powell is a good omen. The US dollar’s strength in world currency markets is in dramatic contrast to the Turkish lira’s free fall since Erdogan usurped Ankara central bank’s monetary policy independence.

With current CPI at 6.8%, US housing prices above their 2007 credit bubble peak, $5 trillion in post-COVID monetary stimulus and speculative manias in everything from cryptos to NFTs to luxury watches, it is obvious that the Fed’s anti-inflation credentials will be challenged by a global rise in inflation expectations and virus related bottlenecks in supply chains.

One thing is certain, emerging market economies with very high debt levels face a new sovereign debt crisis as happened when the Volcker Fed went ballistic against inflation in the 1980’s, when Mexico, Brazil and Argentina went belly up.

The risk of a major fall in crude oil from $74 Brent now to $40 Brent is entirely possible if the Fed’s new anti-inflation crusade and China’s post-Evergrande debt woes choke global industrial growth in 2022/23.

Real US dollar interest rates are negative now to a dangerous degree and the Fed’s new pivot means that highly leveraged companies/asset classes are living on borrowed time, a kiss of death for inflated property markets worldwide and crypto junk which could lose 90% of its current value as successive Fed rate hikes get progressively nastier. An inverted yield curve would mark the end game for an anti-inflation Fed but it would plunge the world into recession in 2023.

The Chinese curse “may you live in interesting times” is about to be enacted again in the financial markets, exactly as it was after the failure of Lehman Brothers 2008, the TMT in 2000 and the Asian currency crisis in 1997.