Mega interest rate hikes indirectly increase purchasing power

Mega interest rate hikes indirectly increase purchasing power
Mega interest rate hikes indirectly increase purchasing power
(c) Daniel Roland / dpa / picturedesk.com
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High inflation

The global economy is facing the effects of the pandemic and the war in Ukraine. The most obvious development is high inflation (OECD area: 9.6% y/y in May), triggered by imbalances between supply and demand. Last week, consumer price inflation in the U.S. rose to 1.3% month-on-month in June. Year-on-year inflation was 9.1%.

Low unemployment rates

In part, economic growth (demand) has recovered faster than expected, boosted by very expansionary fiscal and monetary policies. This can be seen, among other things, in the low unemployment rate in the OECD area (5% in May). But the supply side itself has also deteriorated. Supply chains remain impaired and energy and food prices have risen significantly.

Key interest rate hikes

Central banks try to prevent an inflationary spiral by raising key interest rates. The aim of higher interest rates is to weaken demand to such an extent that inflationary pressure falls. The goal of central banks is to achieve a soft landing. In the past, however, key rate hikes have often triggered a recession.

Falling sentiment

Meanwhile, the effects of high inflation are visible. The loss of purchasing power is reducing consumer and business sentiment. Last week, the mood of small and medium-sized businesses in the USA (NFIB index) fell below the level of spring 2020. The same applies to expectations for the German economy (ZEW index).

Note: Past performance is not a reliable indicator of the future performance of an investment.

Increased probability of recession

In addition, two important US-based indicators provide evidence of an increase in the probability of a recession. First, the benchmark 10-year Treasury bond yield has already been below the two-year yield for two weeks (most recently by 0.2 percentage point). Second, initial claims for unemployment insurance show a slight upward trend after reaching a very low level in March. This week, the preliminary purchasing managers’ indices for July in particular will provide an important update on the economic situation.

Strong US dollar

In general, the US dollar is strong against many currencies, not just the euro. Against a basket of currencies adjusted for inflation differentials, the US dollar has reached its highest value since the fall of 1985. This value is referred to as the real effective US dollar. In September 1985, the G5 countries even agreed to devalue the dollar in the Plaza Accord. Even without taking inflation differentials into account, the US dollar is strong. Currently, the nominally effective dollar has reached its highest value since spring 2003. However, the dollar is still far from its 1985 level.

When a country A (USA) becomes more attractive than country B (eurozone), capital flows into country A (USA). The result is a strengthening of the currency of country A (USA) compared with country B (euro zone). It is important to distinguish whether this is a cyclical movement or whether it is a long-term, or structural, shift in fair value.

There are several reasons for the shift in attractiveness toward the US dollar. First, the USD has the characteristics of a countercyclical currency. When global economic indicators fall, the USD has historically exhibited a strengthening tendency.

Second, interest rate parity provides a simple but not always accurate explanation. When interest rates rise more in country A (the US) than in country B (the eurozone), the currency of country A (the USD) strengthens. However, because the long-term “fair” value of the exchange rate does not change (the purchasing power parity), an exchange rate level is eventually reached (a strong USD), above which the higher interest rates of country A (USA), just offset the expected weakening of the currency of country A (USA).

Mega interest rate hikes

The reality, however, is more nuanced. More and more central banks are accelerating their exit from ultra-expansionary monetary policy stances. The Federal Reserve has already raised its key interest rate (upper band) from 0.25% in early March to 1.75%, while for the European Central Bank the first moderate rate hike is not expected until next Thursday (discount rate by +0.25 percentage points to -0.25%). In addition, last week the strong increase in the US consumer price index reinforced expectations for a Fed rate hike of 0.75 percentage points on July 27. In June, the key interest rate was also raised by 0.75 percentage points. Last week, Canada’s central bank raised its key interest rate from 1.5% to 2.5%. Speculation for a “mega” rate move in the US as well, however, was dampened by the decline in long-term inflation expectations in the University of Michigan’s consumer sentiment report (from 3.1% in June to 2.8% in July).

Interest rate differentials between the US and the eurozone show a widening only for this year. The market-priced three-month interest rate differential for December 2022 widened from 1.36 percentage points in early January to 2.62 percentage points most recently. The priced interest rate differential for December 2023 is only 1.56 percentage points and is even slightly below the level at the beginning of January. At 1.74 percentage points, the yield spread between government bonds with a ten-year maturity is also at the same level as at the beginning of January.

Strong currency increases purchasing power

The idea behind this is as follows: Rapid interest rate hikes support the currency. This reduces inflationary pressure because it dampens import prices. This impact channel is particularly relevant at present, because a good part of the high inflation comes from the external side. The firmer the currency, the more inflation is dampened in the medium term, which is why the central bank has to raise the key interest rate to a lower level.

Two structural euro problems

However, the euro faces two other additional problems. First, because there is no common economic and fiscal policy in the euro zone, there is a residual risk of a breakup of the euro zone. The current government crisis in Italy also points to this. The ECB is currently tinkering with an anti-fragmentation instrument. Details are expected next Thursday at the ECB meeting. Second, Europe is dependent on gas supplies from Russia. If gas supplies through Nord Stream 1 do not ramp up this week, the likelihood of a severe recession in Europe increases. But even if gas supplies are ramped up, a permanently higher energy price level looms for Europe. The higher costs mean lower competitiveness. This implies a decline in the long-term fair exchange rate between the US dollar and the euro.

For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management

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Prognoses are no reliable indicator for future performance.

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