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Do climbing interest rates risk recession?
In the latest instalment of our “Thoughts of an FX Trader” article series, Head of FX and Interest Rates Trading Demitri Theodosiou looks at whether central banks tightening policy to tame soaring inflation threatens to tip economies into a slump.
During the Queen’s Jubilee weekend, the Theodosiou family swapped street parties for lakes and mountains in the beautiful country of Austria. My wife is Austrian, and we took the opportunity to have a long weekend seeing her brother, staying near a crystal clear lake in 30-degree Celsius heat with a scenic mountain backdrop. On one of the days, we drove to the bottom of one of the surrounding mountains and hiked up with the kids to a viewing point that showed off the amazing views.
My youngest, Matthias, also known as “the prince of are-we-there-yet”, isn’t a fan of walking any distance and, as usual, began the can-you-carry-me mantra as soon as he could. To save my back, I tried to put off the carrying for as long as possible, and as we walked, Matthias fell further and further behind, slowing the group down. I would call him to encourage him to run a bit to catch up to us, usually in the guise of a game. He would oblige, but every time he caught up, he would be out of breath, and the cycle would repeat, leading to him being carried on my shoulders, much to my back’s discomfort. Safe to say, in the end, he enjoyed the view from the top and the accompanying apple juice made it a worthwhile exercise.
On returning from our trip, it has become evident that central banks have a similar problem. Inflation, which was once seen as transitory, is now runaway and central bankers are running to catch up. We have seen many central banks increase interest rates this year, but more recently, the size of the rate rises is increasing as unusually high inflation is causing policy to be seen as behind the curve. In recent weeks we have seen 50-basis point interest rate increases in the USA, Australia, Canada, and New Zealand, where 25-basis point changes are more common. Even the European Central Bank, which has been sitting at negative interest rates since 2014, is plotting its first interest rate hike in 11 years in the coming months.
The Bank of England is expected to raise interest rates by 25 basis points this week, a fifth consecutive hike, with some scepticism on how many more the economy can take.
This week the market is expecting a further 50-basis point increase in the USA. In fact, at the time of writing, 175 basis points of additional Federal Reserve rate hikes are priced in by financial markets by September, with at least one 75-basis point move. This is a significant and fast tightening, and in a backdrop of quantitative tightening to unwind previous money printing, this continues to drive US dollar strength in currency markets, the overwhelming theme of the year to date. With such tightening of policy across the pond, stock markets have fallen as future cashflows of growth stocks are discounted more heavily, causing risk aversion and feeding a flight to quality that has added more fuel to the stronger US dollar fire.
We have discussed before that some of the reasons for inflation (such as the Ukraine conflict pushing up commodity prices) are out of the control of central bankers, and there is a risk that the velocity of interest rate increases hurts demand to the extent that recessions loom while inflation continues to be elevated. Indeed, the Bank of England was one of the first central banks to begin its tightening cycle late last year and we are already seeing the impacts of a slowing economy - the pound is 8.6% lower at the time of writing against the US dollar than it was on the date of the first UK hike in December.
The Bank of England is expected to raise interest rates by 25 basis points this week, a fifth consecutive hike, with some scepticism on how many more the economy can take with this week’s monthly gross domestic product print showing contraction. The UK economy, in aggregate, has now not recorded a month-on-month expansion since January and acts as a stark reminder that while it may be deemed necessary to increase interest rates globally with such a strong inflationary backdrop, this is not necessarily driven by overheating economies needing to slow down.
After my son ran to catch up with the group, fatigue slowed him down further, and it became so overwhelming that inevitably I had to carry him. If aggressive hikes threaten recessions, then there is a risk we may see central bankers move from running to catch up to needing to put the economy back on their shoulders and carrying it again.
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