We are once again at a crucial point in the world’s economic recovery. Everything must go well or global markets could turn violent.
Over the past four years, the world has been united in its efforts to first ease the economic pain caused by the pandemic and then combat the historic wave of inflation that followed. When the pandemic broke out, central banks around the world cut interest rates to zero – just as they did during the financial crisis. When inflation started to kick in, they started raising interest rates at a rapid pace not seen in decades. They did all this in near-perfect time, which kept the markets stable and predictable. But now the world is in danger of getting out of sync.
The European Central Bank started easing interest rates on Thursday and cut the benchmark interest rate by 0.25%. The move is not only a sign of confidence that the eurozone is in the final stages of its fight against inflation, but also an indication of concerns that the economy needs a small boost to keep going. Investors and economists expect the Federal Reserve to follow suit and cut interest rates in September. And so, the story goes, central banks around the world will begin their coordinated descent toward a soft landing — a perfect calibration of the balance between fighting inflation and avoiding recession.
The point is that reality makes a mockery of experts’ assumptions all year long. Wall Street started the year expecting inflation to cool, the economy to slow to a slower pace of growth and as many as six interest rate cuts from the Fed. Instead, inflation data has been consistently positive and the strength of the US economy has exceeded expectations. This combination means that there is a good chance that the September cut that Wall Street is praying for will never materialize.
“The summer will certainly be interesting,” Tamara Basic Vasilyev, a senior economist at Oxford Economics, told me. Her base case is that everything will go according to plan, but there are caveats: “The Fed has proven its ability to deal with any kind of financial stability challenge. But what if inflation in the services sector continues to surprise positively throughout the summer? It’s becoming clear that they won’t even be able to make cuts in September.”
If the Fed does not cut spending next fall, the US high interest rate regime will be out of step with the rest of the world. And any difference between the US and the rest of the world would send a strange wave of money rushing to American shores. That sudden surge of cash could in turn add liquidity to our financial system, just as the Fed is trying to dry it up and drive up prices throughout the economy. This would make it even harder for the Fed to ease, pushing US policy further away from the rest of the world. Think of it as a vicious circle that prevents the world from having a smooth, soft landing.
Over time, this has the potential to add volatility to already skittish markets. Here in the US, stocks move depending on the mood. Wall Street thinks we’re in for a week of stagflation; the next time it believes a soft landing is coming. This divergence in interest rate policy eventually has the potential to bring that same frenetic energy to the currency markets.
The carry nation
Wind is the result of an imbalance: air moves from areas of high pressure to areas of low pressure. The greater the pressure differences, the faster the wind blows. The same principle applies to the global flow of money: investors chase imbalances, and sometimes things get blown away in the process.
The US already has slightly higher interest rates than other countries; the Fed has an interest rate of 5.25%-5.50%. These differences have allowed Wall Street to create a so-called “carry trade”: investors borrow money from a country with low interest rates, invest it in bonds from a country where interest rates are high, and pocket the difference. In this case, that means moving money from the rest of the world and buying U.S. assets, especially government bonds.
This trade has been popular since the beginning of the year; investment banks like JPMorgan and UBS have recommended it to clients, and a Bloomberg index based on selling the lowest-yielding G10 currencies and buying the highest has already returned 7% this year. The Institute of International Finance reported that in May alone, emerging markets excluding China – where interest rates are also higher – saw bond market inflows of $10.2 billion, mainly as investors took advantage of carry trades such as the sale of Japanese yen to buy Mexican pesos. These trades are “everywhere,” Peter Schaffrik, a global macro strategist at RBC Capital Markets, told Bloomberg. And the more interest rates vary, the more attractive this money march from weak to strong becomes.
What seems like a blow to Wall Street is not such good news for the US and the global economy. At a time when economies in Europe and elsewhere are losing momentum, sucking more money out of these economies will tighten financial conditions as they try to avoid a slowdown – especially in crucial regional data such as German industrial production, which has softened . leave. It will also weaken the euro, making it harder for the continent to import the energy it needs to fuel its economy and making it more expensive to buy American goods. And in Asian economies, where interest rates are already significantly lower than in the US, things could get even messier.
“We expect Japan and South Korea will face challenges in balancing monetary policy to maintain stability as the dollar appreciates,” Nigel Green, the CEO of deVere Group, a global services company, told asset management. “I wouldn’t be surprised if policymakers feel the need to intervene in currency markets or adjust interest rates to manage these effects.”
For the US, more money flowing to US shores has the opposite effect of what the Fed wants to achieve: it drives up asset prices and eases financial conditions. In other words, it makes it harder for the Fed to combat inflation that is aggravating consumer concerns.
“There are legitimate concerns that these inflows of capital into the US will increase liquidity, raising asset prices and inflationary pressures, making it more challenging for the Fed to cut rates,” Green said. “Increased liquidity could lead to inflationary pressures, which the Fed may have to counter by maintaining or even raising rates.”
As Green said, there is one way the Fed can fight back: raise rates even further. But pushing rates even higher could ultimately break the back of the so-far strong American consumer and push us into a recession. It is the same calculation that the ECB makes, although the delay in the EU is greater. Given these drawbacks, the Fed is unlikely to hike rates, creating the perfect market for the carry trade to flourish. And as long as the US data remains choppy – indicating persistent inflation one day and disinflation the next – this carry trade money will end up sloshing around in the economy. This is a dynamic that the central banks of countries that are already cutting interest rates will be keeping an eye on. They already see growth slowing and money will be diverted to the US, where data was relatively strong during the first half of the year. Carry-trade cash takes advantage of the dislocations between world economies that prevent our policies from coordinating. We’re still in the early innings, but the longer this goes on, the bigger the impact will be. For Wall Street, that means a summer of vigilance. For economists, this means that the picture of our economy that they try to piece together with contradictory data becomes even vaguer. It is a time of increasing uncertainty.
Stick the landing
There is of course hope that this difference will only be a temporary situation. If the US suddenly starts publishing weak economic data, it will hasten the Fed’s move to cut rates. And there are signs that EU inflation is more persistent than policymakers would like, which could slow the pace of austerity enough for America to catch up.
There are already signs of a slight slowdown in the US economy: the household savings rate is at a 16-month low, disposable incomes have risen only modestly, and the amount people have to pay on deposits is high. The red-hot labor market has cooled and vacancies have returned to pre-pandemic levels. But not every indicator tells the story of a soft landing. On Friday, May’s jobs report showed that the country had created 272,000 jobs – far more than the expected 182,000. The data whack in the United States continues.
Across the Atlantic, there are signs that inflation in Britain and the EU could be more persistent than policymakers anticipated. EU inflation rose slightly to 2.6% in May, which surprised the ECB, but not enough to stop a rate cut in June. In Great Britain, persistent services inflation, which stood at 5.9% in April, could give the Bank of England reason to pause. Basic Vasilyev of Oxford Economics told me that this suggests that the EU and the US are moving more together than this policy slowdown suggests, and that the current policy gap would remain short. Even the Bank of Canada, which cut rates from 5% to 4.75% last week, is cautiously optimistic that the disruption will be short-lived. “There are limits to how far we can deviate from the United States, but we are not close to those limits yet,” Governor Tiff Macklem said at the Bank of Canada’s latest meeting. Not close…yet.
This rosy outlook is no guarantee: Wall Street still expects three cuts from the ECB and the Bank of England this year. Even with small cuts of 0.25%, three cuts would create a divergence that traders would exploit. And if September comes and the US is still hot, that exploitation could continue throughout the year, exacerbating the conditions that keep monetary policy out of sync. That sucking sound you’ll hear all summer is the sound of Wall Street sucking money from Europe, Canada, Britain and East Asia into the US markets. Policymakers will have to recalibrate. This doesn’t mean we won’t have a soft landing – especially if this moment of disorder is short-lived – it just increases the likelihood of a bumpy ride until we get there.
Linette Lopez is a senior correspondent at Business Insider.
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