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Financial markets enter a dangerous new phase

A strong dollar and surging interest rates are causing havoc

Around the world, financial markets look increasingly distressed. In Britain government-bond yields have surged and sterling has slumped, prompting the Treasury and Bank of England to issue statements attempting to soothe markets. In Japan the government has intervened in foreign-exchange markets to stem the fall in the yen for the first time since 1998. In China the central bank has increased reserve requirements for foreign-exchange trading, in a bid to restrain currency outflows. At the heart of the turmoil is the relentless rise of the American dollar and global interest rates. There is little relief on the horizon.

Each market has its own idiosyncrasies. Britain’s new government plans the country’s largest tax cuts in half a century. Japan is attempting to keep interest rates at rock-bottom levels, bucking the global trend. China’s government is struggling with the consequences of a “zero-covid” policy that has isolated it from the world.

But everyone faces a common set of challenges. Most of the world’s currencies weakened significantly against the dollar. The dollar’s value index against a basket of the rich world’s currencies has risen 18% this year, hitting a two-decade high. The persistent inflation in America and the simultaneous tightening of monetary policy are making the markets overheated.

Before last week’s extreme volatility, the Bank for International Settlements, a club of central banks, noted that financial conditions had shifted, as central bankers’ commitments to rate hikes were priced through markets and US government liquidity. Dam market deterioration. After a brief and modest rally in August, global stocks hit new lows for the year:  The global all-country index fell 25% in 2022. The tension is evident elsewhere, too. US junk bond yields rose to nearly 9%, more than double their level a year ago. Corporate bonds that are only within investment grade quality, with ratings BB the yield is nearly 6%, the highest in 13 years according to Bloomberg.

Fluctuations are expected from corporate treasurers, investors and finance ministries. Hedges are purchased and plans are made accordingly. But conditions now have deviated beyond expectations. Just a year ago, few forecasters predicted double-digit inflation in many parts of the world. When markets perform worse than anyone previously expected, problems arise and policy makers are faced with a list of poor choices.

The Fed’s commitment to crushing inflation no matter the cost is clear. Speaking after the central bank announced its latest rate hike on September 21, its chairman, Jerome Powell, said the chances of a soft landing for the US economy were dwindling, but the Fed was nonetheless committed to lowering inflation. Research published by Bank of America finds that from 1980 to 2020, when inflation rose to more than 5% in rich economies, it took an average of ten years to drop again to 2%.

Expectations for global growth are rapidly receding. In the new forecasts published on September 26, OECD club of predominantly rich countries expects a global GDP will rise by just 3% this year compared to 4.5% forecast in December. In 2023, growth of only 2.2% is expected. As a result, commodity prices fall. Brent crude returned to $85 a barrel, its lowest level since mid-January. Copper prices on the London Metal Exchange on September 26 fell to a two-month low. A weak global economy could also see companies cut their earnings forecasts, following FedEx, the global shipping company, which warned of “global volume softness.” Rising interest rates hurt share prices; less income would be too. An economic slowdown may not even lead to a weaker dollar. As investors head toward the relative safety of the global reserve currency, the dollar often rises during recessions. For countries and companies around the world, this is an ominous prospect.