America’s economic plan will affect the global economy and global stock markets

We are once again at a critical point in the world’s economic recovery. Everything has to go right, or global markets can turn violent.

For the past four years, the world has come together to first ease the economic pain caused by the pandemic and then fight historic inflation. When the pandemic began, central banks around the world cut rates to zero – just as they did during the financial crisis. Then when inflation kicked in, they began raising rates at a rapid clip not seen in decades. They did all this almost on time, which ensured that the markets remained stable and predictable. But now, the world is in danger of falling out of sync.

The European Central Bank began easing interest rates on Thursday, cutting its key rate by 0.25%. The move is not only a sign of confidence that the eurozone is in its last battle against inflation, but also a sign of concern that a little boost is needed to keep the economy rolling. Investors and economists expect the Federal Reserve to follow suit and cut interest rates in September. So, the story goes, central banks around the world will begin their coordinated descent into a soft landing — a perfect calibration of the push-pull between fighting inflation and avoiding recession.

The thing is, reality has been mocking the experts’ assumptions all year. Wall Street began the year expecting inflation to ease, the economy to slow to more moderate growth and six interest rate cuts from the central bank. Conversely, inflation data continues to be warm, and the strength of the US economy has exceeded expectations. This combination means there’s a good chance Wall Street will never make the September cut.

„The summer is definitely going to be interesting,” Tamara Basik Vasiljev, a senior economist at Oxford Economics, told me. His basic case is that all will go according to plan, but there are caveats: „The central bank has demonstrated its ability to combat any kind of financial stability problems. But what if services inflation surprises to the upside in the summer? It’s clear they can’t make the cut in September.”

If the central bank doesn’t slow down the recession, America’s high-interest-rate regime will disappear along with the rest of the world. Any divergence between the US and the rest of the world will send a distinct wave of money onto US shores. A sudden surge of money, in turn, can add liquidity to our financial system just as the central bank tries to dry it up and raise prices around the economy. This would make it more difficult for the central bank to ease, and differentiate US policy from the rest of the world. Think of it as a vicious cycle that stands in the way of the world’s smooth, soft landing.

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Over time, this has the potential to add volatility to already volatile markets. Here in America, stocks move on moods — one week, Wall Street thinks we’re in stagnation; Next, it believes a soft landing is coming. This variation in interest policy has the potential to bring the same frenetic energy to currency markets over time.

The carrying 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 global liquidity—investors chase volatility, and sometimes things get thrown in the process.

The US already has higher interest rates than other countries – the central bank’s key rate is 5.25%- 5.50%. These differences allowed Wall Street to create what it called “theConduct business„: Investors borrow money from a country with low interest rates, invest in bonds from a country with high interest rates, and pocket the difference. In this case, moving money from the rest of the world to buy U.S. assets, especially government bonds.

What looks like a slam dunk for Wall Street is not so good news for the US or the global economy.

The trade has heated up since the start of the year — investment banks such as JPMorgan and UBS recommended it to clients, and the Bloomberg index has already returned 7% this year, based on buying higher-yielding G10 currencies by selling them. The Institute of International Finance reported that in May alone, emerging markets ex-China — where rates are also higher — saw $10.2 billion in bond-market inflows, mostly due to investors benefiting from carry trades. Selling the Japanese Yen Buy Mexican Pesos. These trades are „all over the place,” Peter Shafrick, global macro strategist at RBC Capital Markets, told Bloomberg. And the more the rates diverge, the more attractive this march of money turns from weak to strong.

What looks like a slam dunk for Wall Street is not so good news for the US or the global economy. At a time when economies in Europe and elsewhere are losing momentum, siphoning more money from these economies could tighten financial conditions as they try to avoid recession — especially in key regional data. German industrial production, which is late. That would weaken the euro, which would make it harder for the continent to import the energy it needs to fuel its economy and make it more expensive to buy American goods. In Asian economies, where interest rates are already significantly lower than in the US, things will be even more confusing.

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„We expect Japan and South Korea to face challenges balancing monetary policy as the dollar appreciates,” Nigel Green, CEO of global wealth management firm deVere Group, told me. „I wouldn’t be surprised if policymakers feel they 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 central bank wants to achieve: it raises asset prices and loosens financial conditions. In other words, it’s harder for the central bank to fight inflation that hurts consumers.

„This capital inflow into the U.S. will increase liquidity, increase asset prices and inflationary pressure, making it more challenging for the Fed to cut rates,” Green said. „Increased liquidity can lead to inflationary pressures, which the central bank may have to counter by maintaining or raising rates.”

As Green noted, the Fed has one way to fight back: raising interest rates some more. But raising interest rates further would break the back of the so-far-strong US consumer base and send us into recession. This is the same calculation that the ECB is making, even if the EU’s recession is more significant. Given these drawbacks, the central bank is unlikely to hike, creating the perfect market for carry trade to thrive. As long as U.S. data is chaotic — pointing to sticky inflation one day and flat inflation the next — this carry-trade cash will be a drag on the economy. It’s a dynamic that central banks from countries already on a rate-cutting path are watching. They already see growth slowing, and money will be taken away from the US, where data was relatively strong in the first half of the year. Carry-trade cash utilizes transfers between global economies from coordinating our policies. We are in the early innings, but the longer it lasts, the more impact it will have. For Wall Street, that means a summer of awakening. For economists, the picture of our economy is still hazy as they try to piece together conflicting data. It is a time of great uncertainty.

sticky-down

Of course, there is hope that this difference will only be a temporary affair. If the US suddenly starts printing weak economic data, it will accelerate the Fed’s move to cut rates. There are signs that EU inflation is stickier than policymakers would like.

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There are already signs that America’s red-hot economy is slowing down: the household savings rate is at a 16-month low, disposable income has made only modest gains, and the amount people owe on debt has risen. The white-hot job market has cooled, and job openings have returned to pre-pandemic levels. But not every indicator tells the story of a soft landing. On Friday, the May jobs report showed the country added 272,000 jobs — more than the 182,000 expected. The data view state continues.

There are limits to how far we can diverge from America.

On the other side of the Atlantic, there are signs that UK and EU inflation will be stickier than policymakers expect. EU inflation was 2.6% in May, surprised the ECB but not shocking enough to halt June’s rate cut. In the UK, stubborn services inflation stood at 5.9% in April, which could give the Bank of England reason to pause. Oxford Economics’ Basic Vasiljev told me that this indicates that the EU and the US are moving in tandem rather than this policy backlash and that the current policy divergence will remain narrow. Even the Bank of Canada, which cut rates from 5% to 4.75% last week, is cautiously optimistic that the move will be temporary. „There are limits to how far we can diverge from the U.S., but we’re nowhere near those limits,” Governor Tiff Macklem said at a recent meeting of the Bank of Canada. Not even close yet…

This rosy outlook isn’t a guarantee: Wall Street will be bullish on the ECB this year and the. Bank of England. Even at small clips of 0.25%, three cuts can create a difference that traders exploit. If September comes and the U.S. is still warm, that exploitation could continue throughout the year, exacerbating conditions that keep monetary policy out of sync. The sound of Wall Street pouring money into US markets from Europe, Canada, the UK and East Asia is that absorbing sound you’ll hear all summer. Policymakers need to recalibrate. That doesn’t mean we won’t stick to a soft landing — especially if this erratic moment is brief — but it just increases the odds of a bumpy ride until we get there.


Lynette Lopez Senior reporter at Business Insider.

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