Macro Insights Weekly: Global transmission channels of Fed tightening
- Growth slowdown is on the cards as higher rates get in the way of consumption and investment
- Strong USD is causing FX volatility, with hard currency borrowers seeing soaring debt service costs
- Sovereign risks are rising, with debt service difficulties already visible in some EM economies
- Rising interest rates and widening spreads will be headwinds for both public and private markets
- More asset market correction may follow as expectations of a higher-for-longer cycle get entrenched
Inflation readings are consistently surprising on the upside, with energy prices leading the way, feeding into a variety of goods and services costs. Still-tight labour markets and strong wage demand are adding to costs, shrinking margins for many companies with limited pricing power. Additional challenges are stemming from food insecurity, currency market volatility, and tightening dollar liquidity. Even if year-on-year increases in inflation peak, as we think is about to happen, the high level of prices will cause substantial distress to pocketbooks. Additionally, the decline in the rate of inflation may not be sufficient to cause comfort among policy makers. Inflation going from 8.6% to 4% over the next three quarters would be such a scenario, one that would entail the Fed compelled to continue hiking.
At this point, the US Federal Reserve is on course to hike policy rates by another 175bps this year, which will raise the cost of funding worldwide at a pace not seen in recent memory. There will also be substantial withdrawal of liquidity as bond purchases end and balance sheets begin to shrink. How would these measures transmit through the global economy and financial markets?
Economic slowdown is on the cards, as higher rates discourage credit growth, slow the pace of home purchases and sums spent on renovation. They may also push companies into cutting back on new hires and new fixed capital investment, as both the cost and need for such activities face obstacles. We are looking at 2.5% real GDP growth for the US this year, which would then slow to 1.5% next year. EU faces a grimmer outlook this year; we see growth of 1.4%. Outlook for the rest of the world does not particularly bright either, especially for the commodity importing economies.
The US Dollar, buoyed by rising rates (the DXY up 8.5% this year), is causing currency market volatility, pushing up imported inflation around the world. Weaker local currencies also mean that hard currency borrowers are facing a sizeable rise in debt service costs.
Sovereign risks are rising, with debt service difficulties already visible in some EM economies, including Sri Lanka, Pakistan, and Lebanon, with economic and financial distress spreading in Turkey and a number of economies in central America and Africa.
Rising interest rates and widening spreads will be headwinds for both public and private markets, in the new and old economies. After a couple of years extreme bullishness in the fundraising market, a degree of much-need reality is setting in, especially in the tech space.
Asset markets have already corrected worldwide, as they always do around a rate hike cycle, but more correction could very well be on the cards as expectations of a higher-for-longer cycle get entrenched. Unless one is in the business of selling commodities, relief is not around the corner, we’re afraid.
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