Some central bank watchers believe the Fed and the ECB will have to stop their tightening cycles because of an upcoming recession.

Investors in financial assets have seen a decent start to the second half of the year with equities recovering, longer-term bond yields easing down, volatility moderating and the dollar slipping back. But what may be good for investors may not be so good for central banks and, because of that, there’s a risk of renewed financial market pain ahead.

Why do we say this? To answer, we need to think about what central banks are doing to rid the world of the inflation that has been so destructive to asset prices over the first half of 2022. Clearly, they are lifting policy rates and many are ending quantitative easing and moving towards quantitative tightening. These things are necessary but they are like pushing on a piece of string if financial conditions don’t tighten at the same time.

If you listen to Fed Chair Powell for instance, he does not say that the Fed needs to get rates up quickly. Instead, he says that financial conditions need to tighten – and importantly, the former does not guarantee the latter. In fact, if you look at the Fed rate hike cycles of 2004-2006 and again between 2015 and 2018 you will see that financial conditions actually eased.

Perhaps fortunately, financial conditions have tightened in this current period of policy tightening, but the danger is that if financial asset prices such as bonds, stocks, credit and more all rally aggressively, financial conditions could ease back and actually force the Fed to go even harder. That’s one reason why you are seeing Fed members push back against the market’s current view, which is that inflation could be contained soon and that the Fed could be cutting rates as early as the first half of next year. They don’t want to be pushing on a piece of string.

Quite clearly it is hard for the Fed or anybody else to know how much rates need to rise, how many bonds will have to be sold, and how much financial conditions have to tighten. But there was a salutary lesson before the 2008 financial crisis because 425-bps of rate hikes from the Fed in the space of two years between 2004 and 2006 failed to tighten financial conditions.

For many, including ourselves, this failure to tighten financial conditions meant that the financial excesses that had been building, such as rampant and unchecked financial innovation (remember the era of subprime mortgage securitisation?), were not stopped. They just went on to explode from 2007. Back then, financial conditions did not tighten, and nor did they tighten in the 2015-18 rate-hike cycle because inflation was generally still low, the Fed was being pre-emptive with its rate hikes, and the hikes themselves were done in small 25-bps steps. Fast-forward to today and things could not be different. Inflation has soared, the Fed is playing catch up, and the hikes are big. All these things have meant that financial conditions have tightened during this cycle – so far.

However, they have not tightened enough in Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, given the inflation problem. What’s more, there are already signs that financial conditions are easing and could ease a lot more if the market continues to think that recession is just around the corner with consequences such as much lower inflation (which is good for bonds), and future Fed easing (which is good for equities and corporate credit).

In other words, while the Fed may well continue to lift rates a lot more from here, it could be fighting against the market, rather than relying on the market to be an ally in tightening financial conditions. In a worst-case scenario the Fed might be forced into being more aggressive with its policy tightening than it might hope simply because it is not bringing the markets with it. One way it can try to avoid this situation is to use “guidance” to ensure that traders and investors are in little doubt that the Fed will see this through rather than go all “wobbly”, which was a phrase that former UK Prime Minister Thatcher used to deter the naysayers when the going got tough. The market might be trying to price in the probability that the Fed will either have achieved its goals quite soon, or will go all wobbly and back off, but Mr. Steve Barrow doesn’t think either is likely.