Shock US inflation a rude reality check for already shocked markets

Given their debt levels – Italy’s debt-to-GDP ratio is expected to be close to 150 percent by the end of this year and Greece’s closer to 190 percent – the prospect of rapidly rising European interest rates threatens more economic and political instability for the already fragile economies.

What’s happening in America is obviously of great concern to Europeans and the rest of the world, because a more aggressive approach by the Fed – and it is inevitable that the most recent inflation data will force a more aggressive approach – will affect the rest of the world through capital flows, US dollar borrowing costs and exchange rates.

In Asia and the rest of the heavily indebted developing countries, the combination of the strong dollar, rising interest rates, skyrocketing energy prices and the global economic slowdown threatens.

Even Japan, which doesn’t yet have an inflation problem — its rate was around 2.5 percent — is affected by the exchange rate, with the yen depreciating about 15 percent against the US dollar so far this year. While that traditionally supports Japanese exports, it’s starting to hurt as the cost of the raw materials and energy that Japan imports (and pays in US dollars) is rising.

In Asia and the rest of the heavily indebted developing countries, the combination of the strong dollar, rising interest rates, skyrocketing energy prices and the global economic slowdown threatens.

Rising interest rates in the US pose a dilemma for central banks, such as our Reserve Bank, due to their effect on currency relations and, should their currencies weaken significantly, the prospect of importing inflation via higher import prices. Fed decisions have a major impact on global monetary and policy conditions.

The tech-heavy Nasdaq is down 28.5% since the start of the year.Credit:AP

When Fed Chair Jerome Powell announces the outcome of the Open Market Committee meeting ending Wednesday, it is likely he will see the second 50 basis point hike in this cycle and the Fed’s third rate hike this week. year will reveal. He will almost certainly announce another 50 basis point rate hike and more hikes before the end of the year at the next meeting at the end of next month.

For markets that thought the worst might be over when April data appeared to show inflation had peaked — stock and bond markets reacted positively to that data — the release of May’s numbers was a rough reality check.

The US market plunged another 2.9 percent on Friday, while the Nasdaq index fell more than 3.5 percent.

The overall stock market is now down about 18.7 percent since the start of this year and the technology stock-heavy Nasdaq index 28.5 percent as what — for nearly 14 years — has been the safety net provided by the Fed’s sensitivity to market volatility receded.

Bond yields, which had fallen after last month’s seemingly encouraging signs of peak inflation, have risen.

Two-year US Treasury yields are up about 21 basis points to 3.06 percent this month and 10-year yields are up more than 40 basis points to 3.16 percent. The Australian 10-year bond yield is now 3.67 percent. It started this year at 1.67 percent.

The inflation recovery in the US came on what appeared to be encouraging signs that the worst supply chain problems that had caused the outbreaks were easing, with semiconductor prices plummeting and container shipping costs also falling sharply. . The consumer binge that was a hallmark of the pandemic and post-pandemic environments also appeared to be losing momentum.

The Russian invasion of Ukraine and its impact on energy and food prices and the ongoing disruptions to global supplies due to China’s zero tolerance for COVID (just as Shanghai and Beijing appeared to reopen after strict lockdowns, the massive tests in those major economic centers resumed over the weekend) have created an elevated floor below global inflation levels.

Sustained inflation at levels not seen since the dark days of the 1970s and early 1980s leaves central banks with few options but to push even harder with rate hikes and the continued withdrawal of the massive injections of liquidity from the unconventional policies that have been in place, until recently, since the 2008 financial crisis.

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The expansionary policies pursued by central banks in response to the financial crisis and, more recently, the pandemic had a series of unintended, or at least incidental, consequences, including asset market bubbles and negligible to negative interest rates.

The next installment of the major central banks’ monetary policies will do something similarly transformative, albeit the unintended consequences of the abrupt, inflation-driven reversal in those policies are already taking the world into a very different and even less appetizing direction.

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