Peloton of Hikers
In a road bicycle race, the peloton is the main group or pack of bikers. Bikers in a group save energy by riding close to other riders. You can draw parallels in central banking with this concept (shout out to Manoj Pradhan of Talking Heads Macro for introducing this term to me - his book The Great Demographic Reversal is a must read).
In response to both the GFC and Covid shocks, global central banks eased in unison amplifying the impact of the easing cycle. Much like in biking, the drag on the economy whose central bank that isn't part of the easing peloton increases via relative tightening of financial conditions predominantly through stronger FX rate. This creates a prisoner's dilemma incentivizing other central banks to follow the lead of the larger central banks.
In contrast to easing cycles, hiking cycles over the past two decades for most part have been asynchronous due to different speeds of recovery and inflation dynamics and the peloton framework wasn't particularly relevant. However, this cycle is different in many ways to a typical hiking cycle (refer earlier blog post - The Costanza Hiking Cycle). The inflationary impulse has been global in nature for a few reasons -
Shift in Consumption from Services to Goods
The shift of consumer spending from services to goods is probably single most important difference of the economy for the past two years relative to the decade post-GFC. Goods consumption has a larger multiplier effect on the global economy via globally integrated supply chains. Covid exacerbated and exposed the fragility of global supply chains from concentration risk to China suppliers to bottlenecks in shipping, ports and trucking. This led to large non-linear increases in certain prices creating broad-based goods inflation.
Commodity Shock
The impact of Ukraine/Russia war has accelerated what was already a tenuous situation for commodity supply/demand. With no clear resolution in sight, the pressure on commodity supply is set to persist and while European inflation is the most impacted due to its high reliance on Russian energy, there has been significant spillover to global inflation from the broad-based rise in energy, metals and food prices as well.
Labor Market Support
Unlike the crisis prior to Covid, it was relatively easier to map out the channels through which locking down mobility would impact the economy. The government response pretty much across the globe was swift and effective particularly when it came to the labor market. Though the nature of income support was different between countries, the net outcome was broadly similar that income held up through the deepest recession and there was no real scarring to the labor market. Despite setbacks of Delta and Omicron, once the virus was largely brought under control, the labor markets have tightened back to if not through pre-Covid levels in most developed markets.
Following the Fed pivot in December last year, it has consistently ratcheted up its hawkish intent and backed it up with hiking 50bp and announcing QT at the May meeting. Powell has also teed up at least two 50bp hikes over the next two meetings and set the bar relatively high to see compelling evidence that there is substantial and sustainable improvement in inflation to shift away from the strong hawkish stance.
The implications for other central banks (particularly commodity importers) is that if they lag the Fed is that they will likely see currency depreciation further exacerbating inflationary pressures. This can quickly become a self-fulfilling reflexive process where depreciating FX increases the real rate differential with US further fueling more currency weakness. BOJ is clearly in this situation now and to some extent SNB as well.
The challenge with trying to match Fed's inflation fighting resolve is that the domestic growth dynamic is quite different in many places relative to the US. The European continent faces a substantial negative growth shock due to the Ukraine/Russia war via negative real income shock to consumers and supply/chain issues and higher commodity costs impacting businesses. The ECB and BOE have a tough balancing act. As the Fed goes above neutral, being able to keep up with Fed is going to get a lot more difficult.
The implications for markets is -
Currencies of laggards will continue to be under pressure at least until they pivot hawkishly and a dramatic pivot (as in the case of Riksbank) increases in likelihood supporting implied volatility in these currencies.
Central banks that are following the Fed but have negative growth dynamics and are closer to a stagflation state should see money market curves (reds/blues) invert substantially.
The peloton of central bank tightening means that there is global coordinated pressure on financial conditions and given the lags in policy, it increases the risks of a dramatic and disorderly tightening of global financial conditions down the road.