US is preparing the RBA for some painful decisions

Last weekend the European Central Bank raised eurozone interest rates by 50 basis points. It was the first rate hike since a short-term and ill-fated attempt to normalize its tariff structure in 2011, which sparked an existential crisis in the European Union that only eased when it reversed course and Mario Draghi vowed to do “whatever it takes.” ” to restore stability and keep the European Union from falling apart.

The euro’s weakness relative to the US dollar exacerbated the impact of Russia’s Russia-dependent Europe energy crisis – oil and gas are priced in US dollars – while driving up import costs more generally and offsetting any benefits to exports. Even Germany, an export powerhouse, posted a trade deficit for the first time in decades.

Australia’s RBA may raise interest rates by 0.5 percentage point for the third month in a row when it meets in early August.Credit:Louie Douvis

The ECB, particularly sensitive to the specter of fragmentation – weaker economies and excessive leverage in southern Europe forced into a financial crisis and facing domestic pressure to exit the eurozone by blowing up spreads on their debt – has created/old policy tools to respond to the threat. that.

This new “Instrument of Transmission Protection,” or TPI, is another bond-buying program that will allow the ECB to keep the cost of sovereign debt in economies like Italy’s, although the criteria for intervention remain (one suspect intentionally, to keep market participants guessing) unclear.

Even with a 50 basis point gain, double the one previously flagged by the ECB, Europe is well behind the curve the Fed is now setting.

If the Fed does what bond traders expect and raises US interest rates by 75 basis points this week, the target range for the federal funds rate will be 2.25 percent to 2.5 percent and will be on track to end the year around 3.5. percent to 3.75 percent. .

The ECB’s benchmark deposit rate is now 0 percent and the Reserve Bank rate 1.35 percent, with market expectations that interest rates will approach 3.5 percent in the first quarter of next year.

The Fed is now moving aggressively and forcing other central banks to follow suit if they want to cushion the inflationary effects of a lower exchange rate.

It was a painful decision for the ECB, RBA and their peers if they were to avoid too wide a difference in monetary policy with the Fed and the currency depreciation and capital outflows they could provoke.

The pressure is most acute in Europe where yields on debt issued by Italy and Greece are already above 3.2 percent, with the gap between their debt yields and German bonds, which yield around 1 percent, now above 200 basis points.

Political dysfunction in Italy following the collapse of Draghi’s government last week; its debt-to-GDP ratio of around 150 percent and its status as the third largest economy in the European Union means its finances and the interest costs of its debt will be the main concern of the ECB. If TPI were to be deployed, Italy would likely be the main beneficiary.

The ECB raised rates last week but remains well behind the curve now set by the Fed.Credit:AP

While conditions in Europe have been significantly exacerbated by the impact of Russia’s invasion of Ukraine on energy supplies and costs, at a macro level that is the general picture.

Italy and Greece, with their volatile politics, poor economic management and unsustainable debt levels in a normalized interest rate environment – ​​an environment not experienced since the 2008 financial crisis – are particularly vulnerable to rate hikes and, if the eurozone wants to remains intact, must be effectively redeemed by the stronger northern European economies.

The bailout came under harsh conditions that almost led to “Grexit” and “Quitaly” and the breakdown of the eurozone.

The Fed and other Anglosphere central banks and governments don’t have to face that existential challenge but still have to impose pain on their communities (and raise their government’s interest costs significantly) to bring inflation rates down to sustainable levels.

Load

Bond traders in this market are pricing in a rapid rate hike but a relatively brief but sharp recession before interest rates start to fall, and their economy to resume a more normal growth setup, by the middle of next year.

By then, with China considering some relaxation from its overly rigid response to the COVID outbreak and, hopefully, some resolution to the war in Ukraine, supply-side issues may have eased. That’s the optimistic case.

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