Who would have thought the world could receive so many blows as the global economy struggles to recover from the Covid-19 catastrophe? But having suffered a succession of further shocks from the global supply chain shortage, the Ukraine war
, the inflation crisis and tighter monetary conditions, it’s no wonder pessimists think we could be heading into another slump.
The global economy is running ragged right now. The last thing it needs is another potent shock, just at the point when the recovery is at its most vulnerable and global policymakers’ defences are low. But “black swan” events
come out of the blue and strike when least expected, like the global financial crisis in 2008.
The worry now is that those institutions charged with safeguarding global financial stability – governments and central banks – could be responsible for the next big credit event which sets back global recovery for years.
The world still bears too many scars from the 2008 financial crisis
, which left the global economy weakened and financial stability at risk. Years of monetary and fiscal super-stimulus have left a legacy of problems which global governments and central banks are struggling to resolve from a weak position.
The impact of so much policy accommodation since the 2008 crash and during the Covid-19 crisis has brought with it a whole host of potential dangers. Not the least of these are ultra-low global interest rates
and bond yields which fail to reflect the growing credit risk from governments issuing so much debt and central banks printing so much cheap money.
The challenge facing central banks
is normalising interest rates while simultaneously trying to shrink their bloated balance sheets, offloading surplus stockpiles of government debt accumulated under quantitative easing programmes.
The retreat from quantitative easing is exacerbating global economic headwinds by raising borrowing costs for consumers, businesses and governments at the worst possible moment. As the US Federal Reserve has switched from super-easing to a sharp tightening mode
, 10-year US Treasury bond yields have more than doubled since the start of the year to reach a recent peak of 3.5 per cent.
Given the rate at which US bond market sentiment is unravelling, a return to pre-2008 Treasury yields above 5 per cent could be on the cards soon. Rising US bond yields have caused US mortgage rates to hit levels not seen for several years, hurting affordability for first-time buyers, slowing housing sales and casting a shadow over consumer confidence.
With US consumer price inflation hitting 8.6 per cent in May, its highest level in more than 40 years, it’s no surprise the Fed is on the warpath and taking a more aggressive line on interest rate tightening. The Fed must be careful, though.
With the Fed so intent on prioritising inflation control
over growth, the US bond market is in for trouble. Long bond yields are pressing higher and credit spreads are widening at a faster pace, especially as more accumulated quantitative easing assets are dumped back into the market.
The Fed’s asset purchase programme has kept Treasury yields low over the years, so US bond yields could go sharply into reverse as the Fed strives to slim down its balance sheet
. From June onwards, the Fed has committed to running off US$47.5 billion per month from its asset pile, rising to US$95 billion per month from September.
The Fed’s switch from net buyer to net seller of US Treasury bonds while pressing ahead with sharp interest rate rises to beat inflation could become a major source of global instability. The contagion effect on global interest rates, bond yields and credit spreads might raise fears that the world could lurch into another major global credit event similar to the 2008 crash and the European debt crisis
which followed between 2009 and 2012.
European markets were only spared complete meltdown by unprecedented European Central Bank intervention and ECB president Mario Draghi’s 2012 pledge to do “ whatever it takes
” to save the euro. The recent widening of the 10-year yield spread between Italian and German government bonds is a worrying symptom of growing investor concern. Europe’s defences could be overstretched.
With Italy’s government debt/GDP ratio running around 150 per cent, Italy needs strong economic growth to stabilise its debt exposure. Without the continuation of low ECB interest rates and unremitting official support, Italy could be a flashpoint for another major credit event.
David Brown is the chief executive of New View Economics