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How does Fed policy affect global financial markets?


6 July 2022

As expected, the second quarter of 2022 was quite the roller coaster for the entire cryptocurrency industry. Not only the most popular digital currencies, such as bitcoin and Ethereum, have taken a major hit, but also some altcoins, which suffered even more significant losses in some cases. The cryptocurrency market came under pressure following the Fed’s aggressive monetary policy tightening cycle which caused the US dollar to strengthen against all alternative assets, including cryptocurrencies. Considering that the US dollar index (DXY) hit its 20-year high against this backdrop, it’s only logical that investors made their choice in its favor, pulling away from the blockchain assets that had been losing value since the end of last year. It’s worth noting the correlation between bitcoin and the traditional stock market, observed for the last couple of years, as a result of which crypto investors began to copy the actions of ordinary stock traders. For this reason, as soon as it became clear that the Fed was determined to take aggressive steps to fight inflation, many investors fled the US stock market, resulting in an outflow of funds from cryptocurrencies as well.

In addition to the Fed’s policy tightening moves, the collapse of algorithmic stablecoin TerraUSD (UST) and its sister coin Luna, which tumbled in a matter of hours, put more pressure on the crypto industry.

Following the incident, many governments stressed the need for appropriate regulation of stablecoins. For example, the UK Treasury proposed to bring systemic “digital settlement asset” firms within the Financial Market Infrastructure Special Administration Regime (FMI SAR) to ensure the return or transfer of customer funds and custody assets in the event of another collapse of stablecoins. And while it sounds like a decent initiative, the increased oversight of the stablecoin sector could put an end to anonymity and negatively affect the entire crypto industry.

Hardly had the UST turmoil subside, a new dumper appeared on the cryptocurrency market – the potential bankruptcy of Three Arrows Capital, one of the world’s biggest crypto-focused hedge funds, which managed about $18 billion. Market participants concluded that Three Arrows Capital’s potential insolvency was directly related to the Terra-Luna situation. In fact, they are links in the same chain. The Three Arrows Capital cryptocurrency hedge fund heavily invested in the Luna project. After the collapse of the latter, an investment of almost $560 million turned into dust. Word on the street is that the enormous losses on the Luna token forced the fund management to resort to margin trading using high leverage, which often leads to disastrous results.

Considering that Bitcoin has recently tested its multi-year low of $20,000, and Ethereum has plummeted to $1,000, the probability of the fund’s liquidation has increased significantly. If this happens, given the size of the fund, the consequences for the market could be catastrophic.

The collapse of such a high-profile crypto fund can unleash a massive liquidity crisis, especially considering that the rates of capital outflow from cryptocurrencies are already breaking multi-year records. In this scenario, we can well expect a further collapse of BTC to $15,000 and lower. For those who think this is unlikely, just remember that a month ago, the UST stablecoin was at the top in terms of cryptocurrency capitalization, and today it is worth nothing. Given the above, we believe that the downside potential of BTC/USD has not yet been exhausted and that the asset may test a new bottom very soon.

USD/JPY pair: how do bond yields affect the exchange rate?

The USD/JPY pair remains one of the fastest-growing currency pairs. In the second quarter alone, the U.S. dollar has recovered against the yen by more than 1,000 points, soaring from 122.00 to 135.00 and hitting its highest in more than 20 years. If we look at the pair’s movements since the beginning of the year, the result is even more remarkable – the price has recorded growth by almost 2,000 points.

In our latest quarterly report, we mentioned that the bullish outlook for the USD/JPY could be explained by an apparent divergence between the Federal Reserve and the Bank of Japan monetary policies. Now, this contrast has become even more pronounced. The Fed has already begun its aggressive rate hike cycle to tackle inflation and prevent the consumer price index from rising even more. Generally, higher borrowing costs tend to push the local currency up as local assets become more attractive to investors. This is exactly what is happening to the U.S. dollar.

Let us recall that the Fed’s management has repeatedly stressed the need to curb inflation, adding that the regulator is prepared to go to great lengths, including a 3-4% rate hike by year-end, which will undoubtedly serve as a tailwind for the dollar and U.S. bond yields.

In contrast to the Fed, the Bank of Japan refuses to raise the key rate and scale back its monetary easing, focusing more on maintaining economic activity rather than fighting inflation. Moreover, the Japanese regulator has even committed to unlimited quantitative easing, i.e., buying an unlimited amount of 10-year Japanese government bonds and defending its 0.25% yield target. This means that as soon as the bond yields rise, the Bank of Japan begins to actively buy them, bringing the yield back down.

Unlike Japanese debt securities, the yield on U.S. 10-Year Treasury Note is kept around 3%, reflecting the influence of rising inflation expectations and the Fed’s aggressive policy to accelerate the key interest rate. Currently, the yield spread between American and Japanese government bonds is at 293 points, which means that the yield of U.S. bonds is 2.9% higher.

That being said, such a striking discrepancy between 10-year Japanese government bonds and U.S. 10-Year Treasury Note yields (0.25% versus 3% respectively) makes the yen a victim of such a contrast, luring investors to allocate their funds in the U.S., not in Japan.

Earlier, when USD/JPY rose above the 130.00 resistance, market participants feared that possible intervention from the Bank of Japan could put an end to the yen’s selloff at any moment. But Bank of Japan Governor Haruhiko Kuroda soothed those fears at the BoJ meeting in June, confirming the regulator’s commitment to maintaining a “powerful” monetary stimulus. Moreover, the Bank of Japan has made it clear that it considers such cost-push temporary, stressing that it won’t prompt the regulator into tightening, even through verbal intervention. All in all, until the situation changes, the Fed’s tight monetary policy against the ultra-soft BoJ stance will remain the key driver for the USD/JPY growth.

EUR/USD: Is the pair heading for parity?

The current economic situation in Europe isn’t much different from that in other developed countries. The EU economy also suffers from rising inflation, which has already exceeded 8%. For the economy struggling with deflation for more than 10 years, this value would have seemed unthinkable a year ago. Given that inflationary pressure in the euro area continues, the European Central Bank (ECB) has to make tough decisions, reducing economic stimulus and gradually tightening its monetary policy. At its last meeting, which took place in early June, the European regulator announced that it would end its quantitative easing, indicating its readiness for the first rate increase in many years as soon as at the next meeting in July. The ECB’s asset purchase programme (APP), which is part of the anti-crisis quantitative easing (QE) program, will also discontinue in early July.

Previously, the ECB intended to start raising rates sometime after the completion of the asset purchase program. Now that the eurozone inflation has hit its record highs, waiting is no longer an option. The European Central Bank has already been criticized for its lack of proactivity and the lost time when it had the chance to take inflation under control before it accelerated dramatically. After the rate increase at the July meeting, the European regulator is expected to deliver another 50-basis-point rate hike at the September 8 or October 27 meeting, followed by another 25-basis-point rate increase on December 15. As a result, the ECB rate may reach 0.5% by the end of the year. Meanwhile, the year-end forecast for the fed funds rate is now 3.75%. It should also be noted that the contrast between the regulators’ rates is quite significant even at the current stage. The current ECB key rate is 0% against the Fed rate of 1.75%.

The interest rate differential clearly benefits the dollar, which keeps strengthening against its European counterpart. In addition, higher yields in the American market will keep luring investors into US assets, further supporting the greenback. In the current environment, the European Central Bank will have to make a considerable effort to convince investors to support the EUR/USD growth above 1.0800. It’s a very unrealistic scenario, given that the regulator has already revealed all the cards, voicing its rate hike plans until the end of this year.

In other words, whatever could help the euro to update local highs has already been fully priced in. Over the past two months, the EUR/USD pair attempted to gain a foothold below 1.0350 twice, but each time buyers returned to the market, hoping that the ECB would declare war against inflation and raise rates by 0.75% or more. Since this is now unlikely, the third attempt to test the 1.0350 mark may well cause the EUR/USD pair to move down to the parity area.

US Dollar Index (DXY) rising as other assets go down

The U.S. dollar index ends the second quarter of this year at its highest level in more than 20 years, holding above 104.00 points. As expected, the dollar received solid support from a radical change in the course of the Fed’s monetary policy. The regulator has finally acknowledged the threat of rising inflationary pressures in the country and decided to actively fight surging inflation by tightening its monetary policy.

The Federal Reserve policy meeting on June 14-15 became crucial for the dollar. The regulator was so determined to tame rapid and persistent inflation that it raised its benchmark interest rate by 75 basis points to 1.5-1.75%, marking its biggest rate hike since 1994. The Fed’s aggressive actions did not come as a surprise to market participants, especially in light of the May inflation data, when the Consumer Price Index (CPI) surged to a new 40-year high. Prices continued to rise despite widespread expectations that inflation would peak following the Fed’s rate hike causing inflationary pressures to ease. Instead, inflation reached 8.6% in May, its highest level since 1992. It’s worth noting that the value was based on the current calculation formula, but if calculated as it was done back in 1992, the inflation rate would have exceeded 15%.

Hopes for the dollar’s further growth intensified after Fed Chairman Jerome Powell promised an ‘unconditional’ approach to taking down inflation and restoring price stability, noting that the regulator was prepared to raise rates further based on the incoming data and the evolving outlook for the economy. According to forecasts, the Fed will raise its rate by another 75 basis points in July, by 50 bps in September and November, and 25 bps in December. According to the CME FedWatch tool, 76.4% of analysts expect the Fed’s funds rate to be in a range of 3,25-3,75% by the end of this year.

In addition to the fund’s rate projections, Fed members slashed their forecast for GDP growth in 2022 to 1.7%, down from 2.8%. The regulator itself seems to doubt that the U.S. will be able to maintain a decent economic recovery. It’s unclear what overall impact the Fed’s moves could have on the economy. Some are concerned that the use of interest rate hikes as a tool to solve the inflation problem could trigger a recession. Goldman Sachs Group Inc. economists warned of a growing likelihood that the U.S. economy would fall into recession. The Goldman team now sees a 30% probability of entering a recession over the next year, up from 15% previously.

Since the U.S. regulator is determined to keep inflation expectations anchored at 2% and has already announced another big rate hike in July, the U.S. dollar has nothing else left but to move up. And a sharp rise in U.S. Treasury yields may become an additional catalyst for the dollar’s upside. The 10-year Treasury yield surged as high as 3.1%, hitting its highest since 2018. According to many experts, the current yield reflects the minimum expectations of how far the key rate can rise. Apparently, the Fed will stay “tough” on inflation, which will keep driving the dollar.

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