Back to square one?

This article was written by Richard Horswill. All views and opinions expressed are strictly his own.

Ongoing wars in Ukraine and Iran are taking their toll on the global economy. The tipping point seems to be in sight particularly as refined oil products are in tight supply due to refinery outages in Russia and in the region of the Strait of Hormuz. Ukraine having attacked Russian oil infrastructure, and Iran keeping the Strait all but shut, whilst the US is attempting to export as much refined product (in particular diesel) as it can to keep the world turning. With crack spreads, the differential between the price of crude and petroleum products, hitting record highs, is it going to be possible for the global consumer to maintain their apparent robust spending as the inflationary impact of the supply shock hits home?

Central banks are at the forefront of the tipping point. Interest rates have been behaving particularly badly for debt laden governments and whilst they can hope for a miracle of the wars ending and price pressures abating, central bankers seem intent on hammering some significant nails into the global economy’s coffin! The ECB has already raised its benchmark rate by 50 basis points in recent months apparently to combat inflation expectations. The assumed second round effects of the supply story. The Federal Reserve may be next to act based upon their data that is always backward looking, and the Bank of England and Bank of Japan, whilst not that keen to raise rates due to significant economic headwinds, will probably be forced to follow the herd for the sake of unity.

Yield curves however might be telling a different story. As the market digests the US PPI and CPI data, and reflects an expectation of a hike by the Fed, the yield curve has flattened. Two year treasury bond rates spiked significantly as traders have seemingly positioned ahead of the the rate decision, whilst increases in longer dated bonds have occurred, but not to the same extent. This could be regarded as either the fear of another operation twist by the treasury secretary Scott Bessent or the curve preparing to invert as the market signals a recessionary outlook and a warning to the monetary authorities. Interest rates should reflect growth and money supply expectations particularly at the longer end of the curve. One suggestion for longer dated bonds moving higher are expectations for AI and the potential for economic miracles (regardless of the buildout cost). Alternatively, could the market be signalling the fear of $40 trillion of US debt, bond market vigilantes and a dollar collapse? (This fear has been mooted for decades and the debt continues to pile up). There seem to be many arguments for yields rising as they currently are however, as the real economy across continents is clearly experiencing a cost of living crisis, the most likely answer seems to be one that is going to be told by the consumer and the process of demand destruction. Thus, the potential for igniting a reversal in yields and a significant stock market correction is not out of the question. The now stagflationary forces heaping pain onto troubled consumers who’s incomes cannot keep pace with price increases, all created by forces outside of the control of central banks, could well trigger circumstances that will crush the real economy. Central bankers will once again be forced to pivot and eat humble pie as their economic models let them down again as they did pre-2008. The low growth economy seems unlikely to going away any time soon, and policy errors have the potential to stimulate a significant moment. Should this play out, the safety mechanism for financial markets will be to flee to the safety and liquidity of government bonds regardless of debt and deficit concerns. (Gold will almost certainly perform well in this stagflationary environment) Governments will be back to prop up spending with commercial banks happy to finance them so as to avoid lending to a beleaguered public in their risk averse world. Interest rates levels will fall back to levels where debt servicing is able to be maintained and the status quo is resumed. This may seem somewhat contrarian, but is an alternative take on the current economic status of the global economy possibly on the verge of yet another shock.

As the title suggests, could we be headed back to where we started? Most mainstream pundits seem to have an optimistic narrative particularly surrounding the wars ending and oil and product prices coming down based upon re-supply, but one needs to recognise all possible downside risks. Governments and central bankers alike have their policy prescriptions which are in principle metered out in good faith, but as we have seen time and time again, they are very bad at recognising tipping points. The resilience of the global economy is ultimately in the hands of the people in it, and when they call it quits by being priced out of the market there is only ever one outcome!