American gain, global pain

The booming economy at home is causing a lot of pain abroad.

We are once again at a crucial point in the world’s economic recovery. Everything must go right, or global markets could turn violent.

For the past four years, the world has been unified in its efforts to first ease the economic pain caused by the pandemic and then combat the historic bout of inflation that followed. When the pandemic set in, central banks around the world slashed rates to zero — just as they did during the financial crisis. Then as inflation set in, they started raising rates at a rapid clip unseen in decades. They did all this in nearly perfect time, which ensured that markets remained stable and predictable. But now, the world risks falling out of sync.

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

The thing is, reality has been making a mockery of experts’ assumptions all year long. Wall Street started the year expecting inflation to cool off, the economy to slow to a more leisurely pace of growth, and as many as six interest rate cuts from the Fed. Instead, inflation data has consistently come in hot, and the US economy’s strength has defied expectations. This combination means there’s a good chance that the September cut Wall Street is praying for may never materialize.

“Summer will definitely be interesting,” Tamara Basic Vasiljev, a senior economist at Oxford Economics, told me. Her base case is that everything will go according to plan, but there are caveats: “The Fed has proven its ability to fight off any kind of financial stability issues. But what if services inflation keeps surprising to the upside through the summer? Then it becomes apparent they can’t even cut in September.”

If the Fed doesn’t cut come fall, America’s high interest-rate regime will be out of step with the rest of the world. And any differential between the US and the rest of the world would send a weird wave of money crashing onto America’s shores. That sudden surge of cash could, in turn, add liquidity to our financial system just as the Fed is trying to dry it up and push up prices around the economy. This would make it even harder for the Fed to ease, further diverging US policy from the rest of the world. Think of it as a vicious cycle standing in the way of the world’s smooth, soft landing.

Fed risks ‘serious consumer recession’ if layoffs hit services: Sternlicht
Over time, this has the potential to add volatility to already skittish markets. Here in the US, stocks move on mood — one week, Wall Street thinks we’re in for stagflation; the next, it believes a soft landing is coming. This divergence in interest policy, over time, has the potential to bring that same frantic energy to currency markets.

The carry nation

Wind is the result of an imbalance: air moving 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 the global flow of cash — investors chase imbalances, and sometimes things get blown over in the process.

The US already has somewhat higher interest rates than other countries — the Fed’s benchmark rate is 5.25%- 5.50%. These differentials have allowed Wall Street to make what is called a “carry trade”: Investors borrow money from a country with low interest rates, invest it in bonds from a country where interest rates are high, and pocket the difference. In this case, that means moving money from the rest of the world and buying US assets, particularly government bonds.

This trade has been hot since the start of the year — investment banks like JPMorgan and UBS recommended it to clients, and a Bloomberg index based on selling the lowest-yielding G10 currencies and buying the highest ones has already returned 7% this year. The Institute of International Finance reported that in May alone, Emerging Markets ex-China — where rates are also higher — saw bond-market inflows of $10.2 billion, mostly due to investors benefiting from carry trades like selling Japanese yen to buy Mexican pesos. These trades are “everywhere,” Peter Schaffrik, a global macro strategist at RBC Capital Markets, told Bloomberg. And the more rates diverge, the more attractive this march of money from weak to strong becomes.

What seems like a slam dunk for Wall Street is not such good news for either the US or the global economy. At a time when economies in Europe and elsewhere are losing momentum, sucking more money away from these economies will tighten financial conditions while they’re trying to avoid a slowdown — especially in crucial regional data like German industrial production, which has come in soft of late. It will also weaken the euro, which will 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. And in Asian economies, where interest rates are already significantly lower than in the US, things could get even messier.

“We expect that Japan and South Korea will face challenges balancing monetary policy to maintain stability as the dollar appreciates,” Nigel Green, the CEO of deVere Group, a global wealth-management firm, told me. “I wouldn’t be surprised if policymakers feel the need to intervene in the currency markets or adjust interest rates to manage these effects.”

For the US, more money sloshing onto America’s shores has the opposite impact of what the Fed wants to achieve: It pushes up asset prices and loosens financial conditions. In other words, it makes it harder for the Fed to fight the inflation that is aggravating consumers.

“There are legitimate concerns that this influx of capital into the US will increase liquidity, driving up asset prices and inflationary pressure, making it more challenging for the Fed to lower rates,” Green said. “Increased liquidity can lead to inflationary pressures, which the Fed might need to counteract by maintaining or even raising rates.”

As Green mentioned, there’s a way for the Fed to fight back: hiking interest rates some more. But jacking up interest rates even further could finally break the back of the until now strong US consumer and send us into a recession. It’s the same calculation the ECB is making, though the EU’s slowdown is more marked. Given these downsides, the Fed is unlikely to hike, which will create the perfect market for the carry trade to thrive. And as long as US data remains choppy — pointing to sticky inflation one day and disinflation the next — this carry-trade cash will end up sloshing around in the economy. This is a dynamic that central banks from countries already on their rate-cutting path will be watching. They’re already seeing growth slow and, on top of that, will have money sucked away to the US, where data has been relatively strong through the first half of the year. Carry-trade cash exploits the dislocations between global economies that are keeping our policies from coordinating. We’re in the early innings, but the longer this goes on, the more of an impact it will make. For Wall Street, that means a summer of vigilance. For economists, it means the picture of our economy that they’re trying to cobble together with contradictory data is even blurrier. It’s a time of increased uncertainty.

Sticky-ing the landing

There is, of course, hope that this divergence will be only a temporary state of affairs. If the US suddenly starts printing weak economic data, that will hasten the Fed’s move to cut rates. And there are signs that EU inflation is stickier than policymakers would like, which could slow the pace of cuts enough for America to catch up.

There are already signs of a slight tempering of America’s red-hot economy: The household savings rate is at a 16-month low, disposable incomes have made only modest gains, and the amount that people have to pay on credit balances is elevated. The white-hot job market has cooled, and job openings have returned to prepandemic levels. But not every indicator is telling the story of a soft landing. On Friday, May’s jobs report showed that the country created 272,000 jobs — way more than the 182,000 expected. The data seesaw stateside continues.

On the other side of the Atlantic, there are signs that UK and EU inflation could be stickier than policymakers had foreseen. EU inflation ticked up slightly to 2.6% in May, surprising the ECB but not shocking it enough to stop a June rate cut. In the UK, stubborn services inflation, which came in at 5.9% for the month of April, may give the Bank of England reason to pause. Oxford Economics’ Basic Vasiljev told me that this indicated that the EU and US were moving more in tandem than this policy lag suggests and the current policy divergence would remain short. Even the Bank of Canada, which cut its benchmark rate to 4.75% from 5% last week, is cautiously optimistic the dislocation will be momentary. “There are limits to how far we can diverge from the United States, but we’re not close to those limits,” Gov. Tiff Macklem said at the Bank of Canada’s latest meeting. Not close… yet.

This rosy outlook is not a guarantee: Wall Street still expects three cuts this year from the ECB and the Bank of England. Even in little clips of 0.25%, three cuts would create a divergence traders would exploit. And if September comes and the US is still hot, that exploitation could continue all year long, exacerbating the conditions that are keeping monetary policy out of sync. That sucking sound you’ll hear all summer is the sound of Wall Street slurping money from Europe, Canada, the UK, and East Asia into US markets. Policymakers will have to recalibrate. This doesn’t mean we won’t stick a soft landing — especially if this disordered moment is brief — it just increases the odds of a bumpy ride until we get there.