Interest rate hikes and table contraction have been accelerating. Recently, Fed officials frequently cited 1994 as the reference object of this round of tightening cycle. Since the Fed raised interest rates for the first time in March 2022, the market's expectation of raising interest rates during the year has exceeded 200bp. Since 1990s, only the interest rate increase in 1994 reached a similar range (250bp). The special feature of 1994 is that the economy achieved a rare soft landing under the radical interest rate increase.
In addition, from the performance of major assets, there are indeed many similarities between 2022 and 1994, but the performance of the US dollar index is very different. The US dollar index has appreciated by 3% in the first quarter of 2022, but the US dollar depreciated by more than 8% in 1994. Observing the performance of the bond market in that year, after the sharp rise at the beginning of the year, the yield of 10-year Treasury bonds basically remained volatile from May to September, while the Federal Reserve raised interest rates by 100bp in the same period.
We call the above-mentioned "economic soft landing", "great depreciation of the US dollar" and "interest rate hiked bonds do not fall" the three puzzles of 1994. We try to analyze the similarities and differences between 2022 and 1994 from these three puzzles, and look for clues of policy and asset changes.
Puzzle 1: "economic soft landing"
Holding down the signs of inflation, "forward-looking interest rate hike" is an important basis. After Volcker's period of controlling inflation in the 1980s, in 1994, the Federal Reserve under Greenspan attached great importance to inflation and adopted the framework of "forward-looking interest rate hike", which decisively raised interest rates when the output gap has not turned positive and there are signs of inflationary pressure. The advantage of this is that the economy has a better cushion in terms of kinetic energy and space.
Monetary policy is flexible enough to cut interest rates decisively. The Federal Reserve raised interest rates for the first time in February 1994 and the last time in February 1995 (50bp). Three weeks later, when hearing in Congress, Federal Reserve Chairman Alan Greenspan hinted that he might respond in advance to the economic recession. In July 1995 and January 1996, the bank cut interest rates twice (instead of waiting for a recession).
Luck is also important. The stability of the external environment is an important guarantee for the "accurate regulation" of the Federal Reserve. In 1994, Germany and Japan came out of recession and the global resonance recovered; Major countries have reached multilateral trade agreements and the WTO is about to be established; Russia is still under Yeltsin, who is close to Britain and the United States; The biggest increase in oil prices is 47%, and the annual increase of 25% is still controllable. As former Fed chairman Yellen said in his book:
Although there is no doubt about the cleverness of the Fed's policy transformation, the Fed is also lucky that there was no major shock to undermine the economic soft landing it tried to achieve between 1994 and 1995.
It is difficult for the United States to achieve a "soft landing" under radical austerity. As shown in, the current round of fed interest rate hike has lost its "first hand advantage", and the positive output gap means that the Fed's interest rate hike is lagging behind. Under this condition, the tightening of financial conditions brought by tightening will have obvious side effects on the economic momentum, which has been reflected in the data of us PMI
In addition, in the external environment, the central European economy has not stabilized, and the epidemic and geopolitical impact continue, which will undoubtedly make it more difficult for the Federal Reserve to regulate the economy and inflation. Looking ahead, the Fed may have to make a trade-off between turning to easing earlier than planned and using recession to control inflation. 2024 is an election year, and the economic recession as a presidential curtain call may not be the outcome expected by the White House.
Puzzle 2: "great depreciation of the US dollar"
Why did the dollar index continue to depreciate under the radical interest rate hike of the Federal Reserve in 1994? This may be the biggest puzzle in the performance of core assets in the United States and even the world at that time.
The weakness of the US dollar in 1994 cannot be explained from the common perspectives of monetary policy, interest rate spread or capital flow. In February 1994, the Federal Reserve started to raise interest rates (until February 1995), and Germany and Japan were in the cycle of interest rate reduction in the same period. Under this background, the long-term and short-term interest rate spread between the United States and other major developed economies (represented by Germany, Japan and Britain) widened, and the correlation with the US dollar index decreased significantly, or even a certain negative correlation appeared. In terms of cross-border capital flows, except at the beginning of the year, foreign investment continued to allocate American assets (especially American bonds) in 1994, while American investors continued to reduce their holdings of overseas assets. The resulting net capital inflow also did not constitute the basis for the depreciation of the US dollar.
We find that the above three aspects essentially judge the exchange rate from the perspective of capital arbitrage and capital flow, that is, the capital tends to flow to high interest assets and push up the exchange rate of relevant currencies. But in addition, as the world's most important reserve currency, the US dollar plays an important intermediary role in the global economic and financial system. Its particularity lies in that the US dollar exchange rate is also a thermometer of the global economy and trade, that is, the global economic recovery and trade expansion often correspond to the depreciation of the US dollar.
The global resonance recovery represented by Germany and Japan in 1994 is an important driving force for the weakening of the US dollar. From the end of 1980s to the beginning of 90s, the rate hike in Germany and Japan led to the European monetary crisis (for example, the Soros pound in 1992) and the bursting of asset bubbles in Japan. In 1993, Germany and Japan both fell into negative growth. However, in 1994, the global economy and trade bottomed out and rebounded significantly. On the one hand, the German and Japanese economies resonated and recovered to support the global economy; On the other hand, important agreements were reached in the global multilateral trade agreements in 1994, and the world trade organization was officially established in January 1995. With the acceleration of globalization, Global trade expanded significantly.
The first mock exam is not unusual in history. Even if the Federal Reserve is in a tight cycle, global economic recovery and trade expansion will lead to weaker dollar performance, such as 2013 and 2017.
In the 21st century, with China's integration into the global trading system, China has gradually replaced Germany and Japan as the (non US) engine of the global economy, and China's economy has become a forward-looking indicator of the trend of the US dollar index. As shown in, although the RMB is not in the basket of currencies of the US dollar index, China's impact on the US dollar is mainly through the way of affecting the growth of global non US economies: China's economic recovery - driving the global economic recovery (represented by Germany and Japan) - the weakening of the US dollar index.
There are two important conditions for the effective transmission of China's economic recovery: one is that China's economy can be stabilized and the other is that China's economy can be stabilized internally. These two points will face certain constraints in 2022.
Taking history as a mirror, whether from the perspective of policy, interest rate spread or the logic of global economic recovery, the US dollar index in 2022 will not follow the old path of 1994 and will remain relatively strong in the second quarter. From the perspective of policy and interest rate spread, the Federal Reserve has entered the cycle of accelerating interest rate hike. Affected by the conflict between Russia and Ukraine, the European central bank remains cautious, while the Bank of Japan continues to adhere to the policy of controlling the yield of long-end treasury bonds. Under the policy differentiation, the nominal and real interest rate spread between the United States, Europe and Japan is widening.
The instability of China's economy and the tug of war between Russia and Ukraine are the core gambling points of the logic of global recovery and weakening of the US dollar. Since 2022, the driving force of China's steady growth is still not enough to hedge against the weakness of real estate. The transmission from the inflection point of real estate policy to real estate stabilization still needs time. Superimposed on the impact of a new round of epidemic outbreak, China's economy will hit the bottom twice in the second quarter. The impact of commodity production, financial market turmoil and geopolitical tensions caused by the seesaw and continuous fermentation of the conflict between Russia and Ukraine will become an important obstacle to the resonance and recovery of the global economy.
We believe that the US dollar index will stand at 100 in the second quarter of 2022. In addition to the above positive factors for the US dollar, the expectation and landing of the Fed's table contraction in the second quarter will add fuel to the fire of the US dollar index. The US dollar index will stand at 100 in the second quarter, and the peak may appear in May. However, we expect that at the end of the second quarter and the second half of 2022, the US dollar index will fall as more positive signals appear in the Chinese economy and the marginal negative impact of the Russian Ukrainian conflict weakens.
