American bond and currency markets signal a global recession

Another record inflation reading against the backdrop of a tight labor market and rising food and goods prices will, despite the recent declines in oil and therefore gasoline prices, leave the Fed with no choice but to continue raising rates aggressively, even if it does. risk of pushing interest rates up. US economy into recession.

In fact, the drop in oil prices – dropping below $100 a barrel on Tuesday for the first time since dropping briefly below that level in April – also reflects the view among traders in commodity markets that a recession and falling demand are imminent. .

With inflation at an unprecedented rate and such a raw tool monetary policy, it is almost inevitable that [Fed] must induce a recession to try to control inflation.

There are those, including the Fed, who believe that a two-year/10-year inversion, because of their imperfect record in predicting a recession, is less useful as a guide to the economy’s future than a three-month/10-year yield relationship, in which an inversion has been a perfect predictor of past recessions.

The relationship has not reversed, but the premium for 3-month 10-year Treasuries has tightened dramatically, from 234 basis points in May to around 80 basis points.

What bond investors tell us is quite rational. The Fed has no choice but to keep raising interest rates until it is confident that inflation will fall back to its target of around 2 percent, which would require rising unemployment and demand in the economy falling.

With inflation at an unprecedented rate and monetary policy such a raw tool, it is almost inevitable that central banks will have to push into a recession to try to control inflation.

Unwanted consequences

That would have unintended consequences for third parties. Indeed, it already had some effect.
The euro, for example, is at its weakest level against the US dollar in 20 years and only slightly away from parity.

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

A weaker currency is good for exports, making it more competitive, but it imports inflation – goods purchased with US dollars are more expensive in the local currency – and increases the cost of paying down US dollar-denominated debt.

Europe is concerned that, while a weaker euro may benefit export-oriented economies like Germany, it will increase pressure on heavily indebted economies such as Greece and Italy and, perhaps even more threateningly, add to the cost of energy imports over the long term. the region is already experiencing an intense energy crisis as Russia continues to restrict gas shipments to Europe. Oil and gas, of course, is mostly traded in US dollars.

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

‘Crisis after crisis’

In Australia, the drop in the value of the Australian dollar to around US67.5 cents (nearly US76 cents in April) is good news for resources companies and our federal Treasury as it will help to blunt the impact of weaker commodity prices. But it will add to the inflationary challenges – and pressure for higher interest rates – facing 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 tightened, describing a prospective increase in debt servicing costs as “crisis after crisis,” with a third surprise increase in costs. loans following the impact of the pandemic and war in Ukraine. About 30 percent of developing countries and emerging markets are either in or near debt trouble, he said.

Therefore, ridding the developed economies of unsustainable inflation rates would incur significant costs to the global economy, although some economies would suffer more than others.

However, for central bankers, there is no other alternative. In many ways, the purging of excesses, imbalances, and unproductive incentives they have created with their unconventional monetary policies since the 2008 global financial crisis is almost inevitable and unavoidably painful, but necessary.

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