Trouble is hitting the world economy – not as a single spy, but as a battalion. They are doing this in multiple areas including the US, China, and Europe. Combined with new geopolitical tensions in the Middle East, these issues raise the possibility of a full-scale global economic and financial market crisis by the middle of next year.
One of the biggest threats to the U.S. and global economic recovery is the recent spike in U.S. Treasury yields, a key interest rate for the global economy. In just two months, the 10-year Treasury yield jumped from less than 4% to more than 4 3/4%, its highest level in 16 years. This comes as the Federal Reserve warns that interest rates will remain high for an extended period of time to curb inflation and concerns about how to finance the US government's budget deficit of 8% of gross domestic product. This is in response to growing market concerns.
Due to the rapid rise in interest rates, 30-year mortgage rates are already close to 8%, significantly increasing the interest cost of purchasing a car. This must soon be expected to be a major headwind for both home and car sales, just as most households have exhausted their pandemic savings and the government is facing another government shutdown. .
It could also exacerbate problems in the commercial real estate sector, where developers are already struggling with low occupancy rates in a post-pandemic world. The last thing these developers wanted was to have to pay higher interest rates on the more than $500 billion in commercial real estate loans coming due over the next few years.
To make matters worse, the sharp rise in Treasury yields must be expected to lead to a U.S. credit crunch in the near term. It will likely do so by raising questions of widespread solvency in the U.S. banking system in general and regional banks in particular.
Even before the recent spike in bond yields, it was estimated that the U.S. banking system was carrying more than $600 billion in mark-to-market losses on its bond portfolio. Further declines in bond prices would significantly increase these losses. This leaves local banks at a particular disadvantage to absorb an expected wave of defaults in their commercial real estate loan portfolios, which account for nearly 20% of their balance sheets.
It is never a good time for the global economy to see China, the world's second-largest economy and until recently the main driver of economic growth, moving into a clearly slower growth trajectory. When the United States appears to be on the brink of a severe economic recession, it would be a particularly inopportune time for such an event to occur. But that's what appears to be happening now, following the bursting of the country's huge housing and credit market bubbles. The bursting of that bubble, combined with China's very poor demographics, is now raising serious concerns that China is headed for a Japan-style lost economic decade.
Similarly, now seems to be the wrong time for Europe to sink into an economic recession and experience another sovereign debt crisis centered around Italy, which has an economy about 10 times larger than Greece's. However, amid the economic stagnation, the European Central Bank continues to raise interest rates to restore inflation control, and the Italian government has introduced an expansionary budget amid extremely high public debt levels. That outlook now looks very promising. The German economy has already experienced three consecutive quarters of negative growth, as the gap between Italian and German government bond yields widens at an alarming rate.
All of this will have clear implications for U.S. economic policymakers. The Federal Reserve should abolish high interest rates as a long-term policy and begin preparing for a global economic and financial system crisis. At the same time, Congress should take action and begin to address the nation's long-term budget deficit problem in a meaningful way.
Desmond Luckman, a senior fellow at the American Enterprise Institute, is the deputy director of policy development and reviews at the International Monetary Fund and former chief emerging market economics strategist at Salomon Smith Barney & Co.
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