GLOBAL ECONOMY
Introduction:
With the rapid increase in the interest rates by the Central bank of the US, the country's inflation rate for June has come in at 9.1%which is highest in 40 years in the US
Many observers have pointed to an inversion of the US yield curve to argue that the Federal Reserve will not be able to achieve a soft landing for the economy.
US dollar continues to gain against all other currencies, it is what is seen as a reverse currency war, most central banks across the world are trying to raise their interest rates to counter the Fed's action, and to ensure their respective currencies claw back value against the dollar.
The following terms will be important with respect to global economy
BOND YIELD CURVE INVERSION
- Bonds are an instrument through which governments (and also corporations) raise money from people. Typically, government bond yields are a good way to understand the risk-free interest rate in that economy.
- The yield curve is a graphical representation of yields from bonds (with an equal credit rating) over different time horizons. In other words, if one were to take US government bonds of different tenures and plot them according to the yields they provide, one would get the yield curve.
- Under normal circumstances, any economy would have an upward sloping yield curve. That is to say, as one lends for a longer duration –or as one buys bonds of longer tenure –one gets higher yields. This makes sense –if you‘re parting with money for a longer duration, the return should be higher. A longer tenure also implies a greater risk of failure.
- However, there are times when the bond yield curve becomes inverted. For instance, bonds with a tenure of 2 years end up paying out higher yields ( returns /interest rate)than bonds with a 10-year tenure. such an inversion of the yield curve essentially suggests that investors expect future growth to be weak. This is how it works :
- When investors feel buoyant about the economy, they pull money out from long-term bonds and put it in short-term riskier assets such as stock markets. In the bond market, the prices of long-term bonds fall, and their yield (effective interest rate) rises. This happens because bond prices and bond yields are inversely related.
- However, when investors suspect that the economy is heading for trouble, they pull out money from short-term risky assets (such as stock markets) and put them in long-term bonds to rise and their yield s to fall.
- Over the years, inversion of the bond yield curve has become a strong predictor of recessions.
- Over the past few weeks, such inversion is happening repeatedly in the US, suggesting to many that a recession is in the offing.
- The Fed has been raising short-term interest rates, which further bumps up the short end of the yield curve while dampening economic activity.
- the short end of the yield curve while dampening economic activity.
SOFT LANDING
- The processing of monetary tightening that the Fed is currently unveiling involves not just reducing the money supply but also increasing the cost of money( that is interest rate). The Fed is doing this to contain soaring inflation.
- Ideally, the Fed or any central bank would like to bring about monetary tightening in such a manner that slows down the economy but doesn’t lead to a recession. When the central bank is successful in slowing down the economy without bringing about a recession, it is called a soft landing – that is no one gets hurt
- On the other hand, when the actions of the central bank bring about a recession, it is called a hard landing. Given the massive gap between the current US inflation rate of over 9% and the Fed’s target inflation rate-2%, most observers expect that the Fed would have to resort to such aggressive monetary tightening that the US economy will end up having a hard landing.
REVERSE CURRENCY WAR
- The aggressive raising of interest rates by the Fed is causing more and more investors to rush to put money in the US.
- The dollar has become stronger than all other currencies because the dollar is more in demand than those currencies.
- On the face of it, this should make other countries happy because the relative weakness of their local currency against the dollar makes their exports more competitive.
- The US has often accused other countries of manipulating their currency-keeping it weaker against the dollar –to enjoy a trade surplus against the US, this used to be called Currency war.
- However, every central bank is now trying to figure out ways to counter the Fed and raise interest rates themselves to ensure their currency doesn’t lose too much value against the dollar.
- The important thing to understand in this reverse currency war is that a stronger dollar has had a key benefit –imposing cheaper crude oil. A currency that is losing value against the dollar, on the other hand, finds it is getting costlier to import oil and other commodities that are often traded in dollars.
- But raising interest rate is not without risk. Just like in the US, higher interest rates will decrease the chances of a soft landing for other economies as well.
