Financial markets are in chaos. What next for the real economy?

The Federal Reserve began raising interest rates a full six months ago to fight inflation in America. But their resolve to break the soaring prices at any cost to the economy is only now beginning to wane. The most recent central bank monetary policy meeting, which ended on September 21, was followed by dramatic moves in financial markets around the world. The economic consequences will be a little slower in coming, but not weaker.

After the meeting, Fed Chair Jerome Powell said the central bank was “determined” to bring inflation, currently at 8.3%, down to its 2% target. This determination caused government bond yields to rise and equity markets to fall. The 10-year Treasury yield rose nearly half a percentage point. On September 28, they rose above 4% for the first time since shortly after the global financial crisis, before retreating slightly. Higher interest rates in America have boosted the dollar. The dxy, an index of the greenback against half a dozen major currencies, is up almost 18% this year and is now at its highest level in more than two decades.

The downside of dollar strength has been drama elsewhere. In the UK, sterling fell staggeringly, helped by the government’s decision to announce the country’s biggest tax cut since the 1970s. Short-term interest rates rose just as spectacularly. Meanwhile, the euro hit its lowest level in two decades against the greenback on September 26th. Expectations of interest rate hikes from the European Central Bank, which will fight the resulting surge in imported inflation, also pushed euro-zone bond yields higher. In heavily indebted Italy, 10-year government bond yields are not far from a worrying 5%.

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Shocking currency movements have prompted a range of interventions. In Japan, where the central bank is waging an increasingly lonely battle to keep interest rates low, the government intervened to support the yen for the first time since the 1998 Asian financial crisis; The Indian central bank has also intervened to support the rupee (see Free Exchange). China’s central bank requires banks to build reserves when selling foreign exchange derivative contracts, making it harder to bet against the yuan.

The great unknown is the impact of these disruptions on a financial system that has changed significantly since the 2007-09 crisis. Financiers and policymakers alike agree that banks are far safer. But strange malfunctions in less studied corners of the system cannot be ruled out. An example of this came just after the UK gilt markets were hit by the ‘mini-budget’. Pension funds that had used derivatives to hedge against interest rate risk were forced to raise cash to meet collateral requirements. They raised this money by fire-selling long-dated gilts, creating a vicious cycle of selling and higher yields. On September 28, the Bank of England stepped in and said it would buy long-dated gilts to restore order.

Another concern stems from the roughly $24 trillion in private markets investment that has exploded over the past decade. So far this year, they’ve been cut just 11%, analysts at bank JPMorgan Chase estimate, far less than the roughly 20% drop seen in listed stocks and bonds. Should discounts catch up with public markets, the owners of these assets will suffer larger losses. It is unclear who exactly is on the hook.

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The effects on the global economy, on the other hand, are clearer – and that is not good news. Thanks to a natural gas crisis in Europe and a slowdown in the real estate market in China, his prospects were already looking questionable. In forecasts released on September 26, the oecd, a club of mostly wealthy countries, said global GDP would rise just 3% this year, down from the 4.5% it had expected in December . Commodity prices, a barometer of the state of the global economy, have fallen in recent months. The price of a barrel of Brent crude is now in the $83-$88 range, a level not seen since Russia invaded Ukraine. The prices for copper and other industrial metals are also declining.

Recent market volatility will add to the pain. Rising government bond yields lead to higher borrowing costs for households and companies. In America, the interest rate on a 30-year fixed-rate mortgage has risen to 6.9%, the highest since the financial crisis. In the UK, lenders briefly paused some new mortgage lending due to volatile interest rates. Yields on risky high-yield or “junk” corporate bonds more than doubled in the Americas and the Eurozone to 9.4% and 7.8%, respectively.

Europe seems to suffer the most. The energy crisis has already left a long shadow in its wake, with economists forecasting two to three quarters of negative eurozone GDP growth. Annual inflation is already over 9% and a weaker euro will continue to drive up the cost of imported goods. The European Central Bank, which is keen to boost its credibility in the fight against inflation, has signaled that it intends to raise interest rates twice this year in a bid to rein in inflation expectations. This will only deepen the recession on the continent.

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As for America? The world’s largest economy has enjoyed an enviable recovery in recent years, fueled by fiscal liberality during the Covid-19 pandemic. Rising interest rates are weighing on the real estate market, the most interest-sensitive part of the economy. According to the latest Case-Shiller index, released September 27, house prices fell 0.3% month-on-month in July, the sharpest such fall in a decade.

For now, however, there is little sign of a broader slowdown in America. Underlying inflation is still significantly higher than the Fed would like at an annual rate of 6.3%. Unlike the real estate market, inflation tends to take a while to react to higher interest rates. And until it falls, there will be no relief from rate hikes. Mr Powell said he would look for “convincing evidence that inflation is moving lower”. The rest of the world will be just as excited to watch.

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