Inflation has dogged markets this year and is likely to remain high, bringing an end to the era of easy money and increasing the risk that overtightening by central banks will trigger a sharp recession, an “inflation bust”.

Markets want to believe that central banks will blink and change direction, negotiating the economy towards a soft landing. But in our view, a hard landing remains the most likely outcome in 2023. The previous norm of central bank “whatever it takes” intervention during the financial crisis and the pandemic is going or has gone.

Until markets absorb this fully, we could see sharp rallies on the back of expected action by the Fed, only for them to reverse when it doesn’t materialise in the way they expect. Rates should eventually plateau, but if inflation remains sticky above 2 per cent, they are unlikely to reduce quickly even if banks take other measures to maintain liquidity and manage increasingly challenging debt piles.

A key factor to watch is where the dollar goes from here. In 2022, the strong dollar has proved to be a wrecking ball for other economies, both in the developed world and for emerging countries that rely on hard currency debt. If the Fed continues to raise rates, an even stronger dollar could accelerate the onset of recession elsewhere. Conversely, a marked change in the dollar’s direction, potentially as its relative strength and confidence in monetary and fiscal policy making become an issue, could bring broad relief, and increase overall liquidity across challenged economies.

Other parts of the world are on different trajectories. Japan has so far maintained looser policy settings; but any shift away from its current yield curve control could lead to unintended consequences for the yen and potentially add another layer of risk to the already elevated levels of volatility in FX markets.

Source: Fidelity International - 29 Dec 2022