Signs of global stress will test Federal Reserve on economy

Signs of global stress will test Federal Reserve on economy
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Entering 2018, the outlook for global economic growth appeared unambiguously bright for the first time since the financial crisis. World economies were ready to shift out of neutral as the “global economic upswing” that began in the middle of 2016 had become “broader and stronger,” as reported by the International Monetary Fund outlook for this year. While the economic expansion in the United States was arguably long in the tooth, the rest of the world had plenty of runway left with easy money still the motto for almost every central bank outside Washington.

Two years of nearly uninterrupted strength across financial markets validated the synchronized global growth outlook. Market tranquility, however, ended abruptly in February just as Jerome Powell took over leadership at the Federal Reserve. A record spike in the stock market fear gauge, or VIX, could be easily explained away as an isolated event tied to a few ill advised bets that the recent low volatility environment would last indefinitely. But as pockets of market stress pop up more frequently this year, the positive global growth outlook looks increasingly fragile.


Even though the Fed focuses primarily on domestic economic performance to formulate monetary policy, Chairman Powell and company must increasingly consider the world view. International economies are more interconnected than ever before through long term trends towards globalization. The reserve currency status of the dollar puts additional responsibilities on the Fed as the de facto central bank.

The Fed under Janet YellenJanet Louise YellenHow lawmaker ties helped shape Fed chairman's COVID-19 response Fed chair issues dire warnings on economy Black Caucus moves to front and center in COVID fight MORE specifically referenced global events when considering the end to its extended zero interest rate policy. Following a surprise devaluation of the Chinese yuan in August 2015, members noted that “recent global and financial market developments might restrain economic activity somewhat as a result of the higher level of the dollar and possible effects of slower economic growth in China and in a number of emerging market and commodity producing economies,” as outlined in the September 2015 Federal Open Market Committee minutes.

Just four months later, global central bankers implemented a rumored secret monetary policy agreement known as the Shanghai Accord. The Fed and other central bankers agreed to ease pressures on emerging market economies by delaying additional rate hikes until commodity prices recovered and the dollar weakened. Another global event shortly thereafter, a surprising outcome for the Brexit referendum in June 2016, postponed a second Fed rate hike until its December meeting.

A similar story is unfolding today with global vulnerabilities likely to alter the path of Fed policy. Rapidly growing dollar denominated debt issued by emerging markets poses risks to financial markets and economies everywhere. The Bank for International Settlements estimates that dollar denominated debt issued by emerging economies doubled to $11 trillion in the last 10 years. These economies remain the most vulnerable to the Fed hiking rates too quickly and the accelerating pace of quantitative tightening. The Fed is entering uncharted territory for central bankers after a decade of unprecedented global policy accommodation.

Turkey, Brazil, and Argentina have experienced significant currency declines this year and face mounting credit pressures should the dollar strengthen further. A doubling of credit default swap spreads for all three countries, since the start of the year, signifies the heightened fear among investors. Growing political populism across Europe and escalating trade tensions with China further complicate the path for the Fed.

The great debate for markets this year is whether the Fed hikes interest rates a total of three or four times. As recently reported by MarketWatch, there has been growing speculation that Powell was the swing vote at the June meeting that pushed the updated “dot plot” to from three to four hikes. Investors must look to both home and abroad to understand the outlook for Fed decision making. With the global growth outlook dimming rapidly, I believe the Fed will err on the side of caution and tighten more slowly than markets, and now possibly Powell himself, expect.

Mark Heppenstall, CFA, is chief investment officer at Penn Mutual Asset Management. He was previously managing director of fixed income for the Pennsylvania Public School Employees Retirement System and has been managing assets for institutional investors for more than 25 years.