Currencies

America’s bond and currency markets are signalling a global recession

Another record inflation reading against the backdrop of a tight labour market and rising food and goods prices will, despite the recent slide in oil and therefore petrol prices, leave the Fed no option but to continue to aggressively raise rates, even though that risks driving the US economy into recession.

In fact, the fall in oil prices – they fell below $US100 a barrel on Tuesday for the first time since they momentarily dipped below that level in April — also reflects a view among traders in commodity markets that a recession and reduced demand are coming.

With inflation at unprecedented levels and monetary policies such crude tools, it is almost inevitable that the [Fed] will have to induce a recession to try to bring inflation under control.

There are those, including the Fed, who believe the two-year/10-year inversions, because of their imperfect record of predicting recessions are less useful as a guide to the economic future than the three-month/10-year yields relationship, where inversions have been perfect predictors of past recessions.

That relationship hasn’t inverted, yet, but the premium for 10-year bonds over 3-month Treasuries has tightened dramatically, from 234 basis points in May to around 80 basis points.

What bond investors are telling us is quite rational. The Fed has no option but to keep raising rates until it is convinced that inflation will fall back to its target of about 2 per cent, which will require driving unemployment up and demand within the economy down.

With inflation at unprecedented levels and monetary policies such crude tools, it is almost inevitable that the central bank will have to induce a recession to try to bring inflation under control.

Unintended consequences

That will have unintended consequences for third parties. Indeed, it is already having some effects.
The euro, for instance, is at its weakest level against the US dollar for 20 years and only a smidgeon away from parity.

That’s partly because the higher rates in the US are attracting capital flows because of the better yields compared to Europe or Japan. But it’s also because there is an element of a flight to safety because of an expectation that the tighter monetary policies now being pursued by most of the central banks around the world will lead to a global recession.

A weaker currency is good for exports, making them more competitive, but it imports inflation – goods purchased for US dollars cost more in local currencies – and adds to the cost of servicing any US dollar-denominated debt.

The Europeans are concerned that, while a weaker euro might benefit an export-oriented economy like Germany, it will increase the pressure on heavily-indebted economies like Greece and Italy and, perhaps even more threatening, add to the cost of energy imports for a region already experiencing an intensifying energy crisis as Russia continues to throttle gas deliveries into Europe. Oil and gas are, of course, mainly traded in US dollars.

The war in Ukraine, soaring energy costs, the substantial loss of purchasing power from the weaker euro and the European Central Bank’s response to high European inflation rates almost guarantee a nasty recession in Europe.

‘Crisis upon a crisis’

In Australia, the slump in the value of the Australian dollar to about US67.5 cents (it was nearly US76 cents in April) is good news for our resources companies and federal Treasury as will help blunt the effects of weaker commodity prices. But it will add to the inflation challenge – and the pressure for higher interest rates — confronting the Reserve Bank.

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The International Monetary Fund’s managing director, Kristalina Georgieva, warned on Tuesday of a global debt crisis as global financial conditions tighten, describing the prospective increase in debt servicing costs as a “crisis upon a crisis,” with the third shock of increases in the costs of borrowing following the impacts of the pandemic and the war in Ukraine. About 30 per cent of developing and emerging market nations are either in or near debt distress, she said.

Ridding the developed economies of unsustainable levels of inflation is, therefore, going to come at significant cost to the global economy, though some economies will be hurt more than others.

For the central bankers, however, there is no alternative. In many respects, a purging of the excesses, imbalances and unproductive incentives they created with their unconventional monetary policies since the 2008 global financial crisis was almost inevitable and inevitably painful, but necessary.

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