Impact Rising Geopolitical Tensions Could Have on Fed’s Outlook
The August rush of geopolitical issues
In August, the financial markets saw a surge in volatility (VXX) because of rising geopolitical tensions. The markets were concerned as North Korea threatened missile launches that would target the US territory of Guam, and President Trump responded aggressively with his “fire and fury” comment. These types of geopolitical tensions usually affect the financial markets since investors tend to flee riskier assets for the cover of safer assets such as gold (GLD), the Japanese yen (FXY), and U.S. Treasuries (BND).
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Could the Fed’s outlook be impacted by geopolitical risks?
A sudden rise in risk aversion tends to impact the financial markets first. A stable financial market is not one of the Fed’s mandates, but it could impact the Fed’s policies, especially in a tightening phase. Volatility in fixed income markets (AGG) leads to rising corporate bond yields. That could impact the borrowing costs of companies and put financial pressure on them. Those factors could lead to job cuts and a higher rate of unemployment. A higher unemployment rate is something the Fed would want to avoid, so it tends to back down from any rate hike plans in times of rising geopolitical tensions.
Could the Fed take a step back because of the North Korean tensions?
The recent tensions with North Korea may not have escalated enough to cause the Fed to scale down its tightening plans. But tensions still exist and could erupt anytime. The financial markets don’t seem to be pricing in any of those risks right now, and the Fed isn’t expected to move interest rates until the end of this year. Its plan to reduce the size of the balance sheet seems to be in the near term. The Fed is likely to go ahead with its plan of policy normalization, unaffected by the rise in geopolitical tensions. But time will tell.