Financial markets are entering a dangerous new phase

NEW YORK, NEW YORK - SEPTEMBER 23: Traders work on the floor of the New York Stock Exchange (NYSE) on September 23, 2022 in New York City. The Dow Jones Industrial Average has dropped more than 400 points as recession fears grow. (Photo by Spencer Platt/Getty Images)
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Aaround the world financial markets are looking increasingly desperate. In the UK, government bond yields have soared (see chart) and sterling has fallen, prompting the Treasury and Bank of England to issue statements attempting to calm markets. In Japan, for the first time since 1998, the government intervened in currency markets to stem the yen’s decline. In China, the central bank has increased reserve requirements for foreign exchange trading to curb currency outflows. At the heart of the turmoil is the inexorable rise in the US dollar and global interest rates. There is little relief on the horizon.

Every market has its own peculiarities. Britain’s new government plans the country’s biggest tax cuts in half a century. Japan is attempting to keep interest rates at rock bottom bucking global trend. China’s government is struggling with the fallout of a “zero Covid” policy that has isolated it from the world.

But they all face a number of common challenges. Most of the world’s currencies have weakened significantly against the dollar. That dxy, an index of the dollar’s value against a basket of rich-world currencies, is up 18% this year, hitting its highest level in two decades. The ongoing inflation in America and the simultaneous tightening of monetary policy are making the markets feverish.

Just before last week’s wild volatility, the Bank for International Settlements, a club of central banks, noted that financial conditions had changed as central bankers’ commitments to raise interest rates were priced in by markets and the US government’s liquidity-bond market deteriorated. After a brief and modest rise in August, global equities have hit new lows for the year: the msci The All Country World Index is down 25% in 2022. The stress is evident elsewhere too. US junk bond yields have climbed back to nearly 9%, more than double a year ago. Corporate bonds that are just below investment grade quality, with ratings of bbbYield nearly 6%, the highest in 13 years according to Bloomberg.

Volatility is expected by corporate treasurers, investors and finance ministries. Hedges are purchased and scheduled accordingly. But conditions have now strayed far from expectations. Just a year ago, few forecasters were predicting double-digit inflation in many parts of the world. When markets do worse than anyone previously anticipated, problems arise and policymakers are faced with a series of bad options.

The Federal Reserve’s commitment to suppressing inflation at all costs is clear. After the central bank announced its latest interest rate hike on September 21, Jerome Powell, its chairman, said the chances of a soft landing for the US economy were diminishing, but that the Fed was nonetheless determined to bring inflation down. Research published by Bank of America shows that from 1980 to 2020, when inflation rose above 5% in rich economies, it took an average of 10 years for it to fall back to 2%.

Global growth expectations are declining rapidly. In new forecasts released on September 26, the OECD Most Rich Countries Club expects global bip up just 3% this year versus the 4.5% forecast in December. For 2023, it only expects growth of 2.2%. As a result, commodity prices fall. Brent crude is back around $85 a barrel, its lowest since mid-January. Copper prices on the London Metal Exchange fell to a two-month low on September 26th. A weak global economy could also prompt companies to downgrade their earnings forecasts after FedEx, a global shipping company, warned of “global volume weakness”. Rising interest rates hurt stock prices; lower income would be too.

A slowdown might not even result in a weaker dollar. As investors seek the relative safety of the global reserve currency, the greenback often rises during downturns. This is an ominous prospect for countries and companies around the world.

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