Recessions are looming – but that may be good news

The two-year yield on Treasury notes similarly peaked at 3.43 per cent last month but now trades at 2.91 per cent.

The five-year “breakeven rate” – the difference between the yields on 5-year Treasuries and an inflation-protected note with the same duration – has been slipping to levels last seen in September last year, reflecting expectations that US inflation is going to fall significantly.

While the markets seem convinced that inflation is being brought under control, central banks have made it clear that, in the near term at least, they will continue to hike interest rates aggressively to ensure that they kill off the worst inflation rates in decades.

Whether they can do that without tipping economies into recession is the critical question, although it has to be said that, given the extent of inflation within the major economies and the cumbersomeness of the policy tools available, soft landings are improbable.

Avoiding recessions in the major economies is also made more difficult because, after massive binges in response to the pandemic, governments have been significantly winding back their spending.

The combination of tightening monetary and fiscal policies, continuing global supply chain disruptions, pandemic-swollen global levels of debt and housing markets inflated by more than a decade of ultra-low interest rates makes for a very contractionary set of influences.

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The determination of central banks to kill off inflation even as governments return to more conservative fiscal policies is why some analysts believe we might be entering a bust then quasi-boom cycle, with the central banks shifting back to more expansive policies, including quantitative easing, once they are convinced they’ve squashed inflation rates – and their economies.

Complicating any assessment is the volatile global environment.

Russia’s invasion has fundamentally changed the global markets for energy – oil, gas and thermal coal – as Europe and Japan scramble to replace Russian oil and gas with non-Russian supply, driving the price of gas up dramatically (even though they have fallen back a little as the ultra-high prices have started to crimp demand).

China’s on-again, off-again economy – driven by its severe COVID policies – is another source of volatility and uncertainty.

Even though there has been recent easing of some aspects of its “zero COVID” approach, this week new outbreaks in Chinese cities have resulted in more lockdowns.

Avoiding recessions in the major economies is also made more difficult because, after massive binges in response to the pandemic, governments have been significantly winding back their spending.

China, while benefitting from its ability to buy heavily-discounted Russia energy, is also experiencing some pressure from the steep rise in energy costs.

Between its COVID policies, the impact of the big surge in commodity prices – including iron ore – earlier this year and the economic impacts of recent severe floods and droughts, China is experiencing its weakest economic growth in decades.

The iron ore price is a barometer of China’s economic activity levels. Three months ago the price was above $US160 a tonne. It’s now about $US113 a tonne in a clear sign that, despite attempts by China’s authorities to generate economic stimulus via infrastructure investment, the economy is cooling.

That’s probably a good thing for global inflation but not such a positive for global growth.

The other signal that the outlook is getting bleaker is a strengthening of the US dollar as risk appetite continue to shrink and investors pour into the traditional safe haven of the US Treasuries market.

The Bloomberg index of the currencies of America’s major trading partners shows the dollar has strengthened about 10 per cent since the start of this year. That exports, to some degree, inflation and tighter economic conditions to the rest of the world as the cost of imports and dollar-denominated funding costs rise.

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The recent falling back of commodity prices, despite the impact of the war in Ukraine on Russian and Ukrainian exports of energy, grains and fertilisers, may also reflect to some extent that risk-aversion.

Over the past decade there has been a “financialisation” of most of the major commodities – they’ve become products for speculation and investment as well as markets for the physical products, which might be amplifying the traditional inverse correlation between the US dollar and commodity prices.

On Wednesday in the US the Fed will release the minutes of last month’s Open Market Committee meeting. At that meeting the Fed raised its policy rate by 75 basis points, its biggest increase in nearly 30 years.

Those minutes, and US employment data due on Friday, might provide a better insight into the Fed’s view of the future and its likely actions.

Perversely, everyone will be hoping to see the strengthened prospect of an economic slowdown, even of a recession in the US, to provide some hope that the central banks won’t have to drive interest rates up to the stratosphere and drive economies into deep recession to bring inflation rates under some level of control.

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