Last week was like few others in intensity, scope or impact. Global equities plunged in anticipation of a recession. The S&P 500 index fell through its June lows as it lost 4.6% during the week. Bond yields surged as investors realized that any improvement in inflation would be, at best, transitory. Yield on 10-year US Treasurys hit the highest level since 2011. Even more eye-catching, the yield on five-year UK gilts rose by over 50 basis points in a single day, going over the corresponding US yield yesterday for the first time in this cycle.

Just as impressive were movements in currencies. King Dollar, which has become a safe haven in an increasingly uncertain world, jumped to a fresh high as measured by the DXY index, and not seen in 20 years. The UK pound sterling, which had already weakened to about $1.13 mid-week, crashed through several thresholds on Friday, ending the week below $1.09. And as the Japanese yen plummeted to almost 146 to the dollar – the weakest level in the 21st century – the Bank of Japan intervened to support the currency by selling dollars. It was the first intervention by that central bank since June 1998.

Behind these significant moves was the sustained use of central bank policies to offset the impact of structural factors – covid and the Russia - Ukraine war, for example. Markets discovered last week that monetary measures cannot substitute for effective covid vaccines or productive peace talks!

By raising the Federal Funds rate by 75bp on Wednesday, Federal Reserve Chairman Jerome Powell and his colleagues were still followers of the markets rather than lead them – a bigger hike may have given the central bank the credibility to undertake further measures. Markets expect at least one more increase of 75bp before the end of 2021. Furthermore, as he has done at past press conferences, Powell undercut the impact of the tightening move by suggesting that "at some point, as the stance of policy tightens further, it will become appropriate to slow the pace of rate hikes." This, even though inflation remains at historically elevated levels!

Still, investors realized that the Fed will be forced to continue with significant tightening at forthcoming Federal Open Markets Committee meetings, and that the Chairman may not be able to deliver on his promise to slow the pace of interest rate increases. Yield on 10-year Treasurys surged to over 3.8% intra-day yesterday, closing the week at 3.69%. This was a big jump from the 3.46% close the previous week.

Even more dramatic was the increase in two-year Treasury yields from 3.86% to 4.2% over the week as investors became concerned that the Fed would overdo tightening and push the economy into recession. The two-year yield reached the highest level since 2007, and the inversion with the yield on 10-year obligations was the most since 2000. Inversion is another leading indicator of a recession.

Policy action bringing markets closer to reality was not limited to the United States. Fighting high and persistent inflation rates, the Bank of England increased its policy rate by 50bp on Thursday to 2.25%, the highest level since 2008. Any support the tightening may have given the pound sterling was undercut by a £45 billion tax-reduction package introduced yesterday by the new Chancellor of Exchequer, Kwasi Kwarteng. In economic terms, as the BoE was attempting to reduce aggregate demand, the UK government was trying to boost aggregate demand through fiscal stimulus! With the funding for the tax cuts to come from new borrowings, it is not surprising that yields on gilts surged and the pound sterling plunged to levels not seen in 37 years.

Lack of realism reached a new high (or new low?) with the Bank of Japan which continued its short-term policy rate at -0.1% despite the rise in domestic inflation and the increase in global yields. As the yen depreciated massively, the central bank intervened in foreign exchange markets on Thursday. The record of other countries suggests that currency interventions not only do not make up for the absence of proper policy measures – in this case, appropriate interest rates – but also give rise to new distortions with adverse economic consequences.

What does the future hold for investors? If last week was the beginning of markets coming face to face with reality, there is more to come in terms of key developments – further correction in equities, higher bond yields and a stronger dollar. What will bring it all to an end and signal a turnaround to the better?

I have some guesses, all involving policy intervention. One of these is the Fed succumbing to political pressure and reversing policy as unemployment becomes a major political issue. Second, a "credit event" could lead the US central bank to decide that it has to flood markets with liquidity in order to "save the system," notwithstanding the impact on inflation. Third, coordinated currency intervention, along the lines of the Plaza Accord of September 1985, to weaken the dollar for "the good of the global economy". (I am trying to imagine the words of the government leaders who would announce it.)

Questions are: How high is the overall level of officials' pain tolerance, and when will the intervention occur?

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California