Rapidly rising inflation, prompting the US Federal Reserve to raise interest rates, is causing changes in the global financial system, reflected in the strong appreciation of the dollar against other major currencies.
With inflation in the United States over 8%, the Fed is expected to raise its base interest rate by 0.5 percentage points at its meeting next month, with further hikes to come later in the month. year.
When the COVID-19 pandemic began in 2020, major central banks in unison cut interest rates to historic lows to support financial markets, sending stock prices to record highs. But now divergences have opened up because not everyone wants to proceed as quickly as the Fed with interest rate increases.
This led to a rapid appreciation of the US dollar which, according to the FinancialTimes (FT) “tears markets as investors bet most central banks will lag the pace of the Fed’s hikes.”
As a result, the dollar index, which measures its strength against a basket of other currencies including the euro, yen and pound, hit a 20-year high yesterday.
The euro is at its lowest level in five years against the dollar and could fall even further. In trading this week, it has fallen even more than in March 2020 when markets were in turmoil at the start of the pandemic.
While the European Central Bank (ECB) has signaled that it is preparing to tighten monetary policy, it is unlikely to change as quickly as the Fed. This is because of the impact of the war in Ukraine on the euro zone economy with fears that moves to impose a full embargo on Russian energy supplies will have a recessive impact.
The ECB must also act very cautiously, lest too rapid a tightening of monetary policy cause major problems for highly indebted southern European economies, particularly Italy, and lead to a return of the 2012 sovereign debt crisis.
Last week, the pound fell to its lowest level against the dollar since the end of 2020. As the Bank of England (BoE) began to raise interest rates, the growing contraction of the economy British suggests that the increases will not be as big as the Fed.
Retail spending is down, with sales down 7.9% in March from the previous month, consumer confidence is plunging to near historic lows and there are indications of a decline in commercial activity.
According to Chris Williamson, chief economist at S&P Global: “Orders received by manufacturers are almost at a standstill, driven by a growing loss of exports, and services growth has collapsed to one of the weakest since the closures at the start of 2021”.
This has raised expectations that the BoE will not raise its discount rate by 0.5% at its meeting next month, driving down the value of the pound.
The biggest divergence in currency values is between the dollar and the Japanese yen. The Japanese currency has fallen to its lowest level in 20 years against the dollar and further declines are likely. Yesterday, the Bank of Japan made it clear that it was not deviating from its low interest rate regime and would continue to intervene to keep bond yields close to zero.
The yen, normally seen as a safe haven in times of economic turmoil, has fallen 12% so far this year and is ranked the worst performer out of 41 currencies tracked by the the wall street journal (WSJ)—worse than even the Russian ruble and the Turkish lira.
Reporting on the fall of the yen earlier this week, the WSJ noted that “if the yen were a smaller currency, its fall might matter less to financial markets. But the yen is key to global finance, ranking as the third most traded currency in the world. »
The fall will have a significant effect on the $22 trillion US Treasury market, where Japanese financial institutions are the main foreign buyers of US government debt.
But the ability of Japanese financial capital to buy US debt, under conditions where the United States is preparing to sell some of the financial assets it has purchased as part of its monetary tightening policy, is being put to the test. test.
When buying debt, buyers hedge against currency fluctuations to protect the value of their transactions. But currency swings have become so large that the cost of hedging means the extra return an investor would get by holding US rather than Japanese bonds has all but disappeared.
Earlier this month, Japanese Finance Minister Shunichi Suzuki warned of damage to the economy from the falling yen. “Stability is important and large currency swings are not desirable,” he said.
While a weak yen had its merits, the demerits were “more significant in the current situation where crude oil and raw material costs are rising globally,” making these items more expensive.
China is also being negatively affected, amid a battle in government, reported by the FT, over how to handle the effects of the property market crisis on the economy and financial system.
A group led by Vice Premier Liu He is pushing for an easing of credit restrictions that have hit Evergrande and other major property developers. A government adviser, who shares Liu’s view, warned that the continuing problems “could cause bad debts to skyrocket and sink the entire financial sector”.
But this is opposed by another faction in the cabinet who say claims of financial collapse are overblown and the crackdown must continue.
These problems are exacerbated by the interest rate hikes in the United States which have caused the renminbi to depreciate. If China eases its credit policy and monetary policy this fall, it could accelerate and cause capital to flow out of the country.
So-called emerging and developing countries are also affected. The latest report from the International Monetary Fund Global Financial Stability Report noted that a quarter of countries that had issued hard currency debt had liabilities trading at distressed levels.
The Fed’s higher interest rate regime is causing major moves on Wall Street. Earlier this week, the Dow fell 800 points with the S&P 500 index down 2.8% to bring its fall for the year to 12%.
The drop in the technology-heavy NASDAQ index was even more pronounced. It lost 20% on the year and is now at its lowest level since late 2020, erasing all of the gains from 2021.
Rising interest rates and the expectation of further increases are the main factor. Indeed, in the orgy of speculation fueled by financial support from the Fed, the “valuation” of high-tech companies is not based on their actual profits.—many of them make a loss—but on the “expectation” of future benefits.
The “expected” stream of future income—makes it a bet that the company will take—are discounted at the prevailing interest rate, with a higher rate leading to a lower expected value of the business.
And in a warning of developments in the real economy, it was reported yesterday that the US economy unexpectedly contracted at an annualized rate of 1.4% in the first quarter of this year. This trend should continue if interest rate hikes start to hit the housing market.
Fed hikes so far have been small and even the expected hikes are not large by historical standards. But the fact that even these small increases lead to major problems is a further indication of the inherent instability of the US and global financial system.