Global financial markets are undergoing the most painful adjustment since the global financial crisis. Adjusting to the prospect of rising US interest rates, the 10-year US Treasury yield at one point reached 4% this week, its highest level since 2010. Global stock markets have plummeted, and bond portfolios have fallen an astonishing 21% this year.
The dollar is crushing everyone who comes. The dollar has risen 5.5% on a trade-weighted basis since mid-August, in part because the Fed has been raising interest rates, but also because investors are avoiding risk. Governments across Asia are intervening to resist currency devaluation. In Europe, the UK has added fuel to the fire with reckless fiscal policy and is losing investor confidence. And as bond yields soar, the eurozone's debt economy looks the most vulnerable since the sovereign debt crisis a decade ago.
The main cause of market turmoil is the Federal Reserve's fight against inflation. The Fed lost the first three or four rounds after prices started surging in 2021, so things are even more shaky now. The central bank expects to raise the federal funds rate to nearly 4.5% by the end of the year, and further in 2023. The outlook for interest rates has ripples through the U.S. financial system. The cost of a 30 year mortgage is he close to 7%. Junk bond yields are already above 9%, and new bond issuance has dried up. Bankers who take on leveraged buyouts when yields are low suddenly find themselves hundreds of millions of dollars in the red. Pension funds that gobbled up opaque personal assets in search of higher returns when interest rates were low are having to rack up losses as the value of their riskier investments falls.
However, the financial impact of the Fed's monetary tightening is most severe outside the United States. The soaring dollar is hurting energy importers who were already struggling with high costs. After the yuan hit a record low against the yuan on September 28 in offshore markets, China responded by making it harder to sell short the yuan. India, Thailand and Singapore have intervened in financial markets to support their currencies. Emerging market foreign exchange reserves, excluding China, have fallen by more than $200 billion in the past year, the fastest decline in 20 years, according to bank JPMorgan Chase & Co.
Developed countries can usually withstand a strong dollar. In fact, today they are showing more signs of impending stress. Some of the worst performing currencies in 2022 are those of the wealthy. Sweden raised its interest rate fully on September 20, but its currency still depreciated against the dollar. Britain has been unable to attract much foreign capital as bond yields have soared. The Bank of Korea lends foreign exchange reserves to the National Pension Fund to reduce the dollars it buys on the open market. In Japan, the government intervened to buy the yen for the first time this century, despite the central bank's seemingly ironclad determination to keep interest rates low.
Part of the explanation for the pressure on developed-market currencies is that many central banks have been unable to keep pace with the Fed's tightening efforts, and for good reason. This is because the economy is weak. The energy crisis is pushing Europe into recession. South Korea and Japan are suffering from the knock-on effects of China's economic slowdown brought about by the housing crisis and zero-corona policy.
A strong dollar will effectively export the United States' domestic inflation problem to countries with weaker economies. They can support their currencies by raising interest rates in line with the Fed, but at the cost of lowering growth even further. Britain has the worst of both worlds. Markets now expect the Bank of England to set the highest interest rates for the richest nations next year, but the pound remains weak. If banks raise interest rates, the housing market could collapse.
Even the U.S. economy, which has shown resilience in the face of headwinds this year, is unlikely to continue growing through an interest rate shock as severe as the one currently facing. Home prices are falling, banks are cutting jobs and economic bellwethers FedEx and Ford are warning about profits. It is only a matter of time before the unemployment rate starts to rise. A slowdown in the economy is ultimately necessary to restore price stability, and it would be crazy for the Fed to allow annual inflation of 8.3%, mostly due to domestic inflation. However, rising interest rates will damage the real economy and cause suffering. Global financial markets are also beginning to realize this. â–
