Ichiro Suzuki Unexpected a year ago, major central banks around the world are finding themselves in a war against the worst inflation in decades, which was suddenly brought back to life. In the U.S., the euro-zone and the U.K., inflation rate is hitting double-digits or close to them. Central banks, notably the Federal Reserve Bank, are aggressively jacking up interest rates in a manner not seen since the years of Paul Volcker’s Fed chairmanship, in order to contain inflationary expectations. In response to re-emergence of inflation, long-term interest rates have made it clear that 40 years of relentless down cycle that started in 1981 was already a history. In early years of the 21st century, the global economy built a considerable amount of wealth on economic growth and rising trade. American consumers were spending as if there was no tomorrow and Chima, as a new WTO member, catered to demand from the U.S. China grew fiercely and other emerging countries also posted markedly higher growth rates than the developed world. Having been punished severely in the Asian Financial Crisis near the end of the 20th century, Asian countries drove themselves hard to push exports to the U.S. and other developed countries. They vowed to themselves that they would never suffer that misery again, and accumulated foreign exchange reserves ferociously so as not to be at the mercy of speculators. A combination of a weak dollar and stronger global growth rates drove commodity prices high, thus enriching their producers. America’s large current account deficits and a falling dollar sprayed greenback notes in the international financial markets, making coffers of exporters to the U.S. awash with cash. Amid a sudden surge in wealth in the developing world, there was only one asset class that was large enough to park their huge amount of cash. It was U.S. Treasury securities, which has unmatched depth of the market, liquidity, and stamped with AAA ratings at that time. Sovereign wealth funds that were already in place for a long time began to display their might, by recycling their massive surpluses, and a vast amount flowed into the U.S. fixed income securities market while also huge amounts went into riskier assets, too. In 2003, witnessing Treasury notes’ yields falling at a time when the U.S. economy was recovering from a recession, Fed Chairman Alan Greenspan famously called the bond market a “conundrum”. He feared deflation might be lurking behind unusually low bond yields. The conundrum led to the beginning of a tightening cycle later than it should have been. An earlier first rate hike than in the middle of 2004 might have been more effective in containing house prices from rising higher. As it turned out, China was buying T-notes, recycling their swelling FX reserves. As this episode shows, abundant reserves among developing countries had monumental effects on the direction of long-term interest rates. There was simply too much savings in the world, pushing down interest rates. In 2022, the tide has turned. After ending a 40-year run, U.S. long-term interest rates are moving up north distinctly. What was understood as transitory price hikes in 2021 has developed into a full-blown inflation of near double digit rates that were last seen at the outset of the 1980s. Borrowing from the playbook of Paul Volcker, Fed Chairman Jerome Powell is raising rates aggressively, by 0.75% every time the Federal Open Market Committee (FOMC) meets. Higher yields mean lower prices of bonds, thus reducing the value of securities held by investors, be they individuals, institutional investors or foreign governments. Higher interest rates, therefore, are adversely affecting foreign exchange reserves and SWFs around the world. In addition, higher Treasury yields are driving up the value of the greenback against almost all the currencies on earth. A strong dollar tightens financial conditions around the world. Some governments are responding to the mighty greenback by intervening into the FX market, by selling the dollar and buying their own currencies. Selling the dollar is done by dumping their precious holding of Treasury securities. History has proven that unilateral FX market interventions never work but they still do it. History is also littered with sorry experiences of developing countries’ burning wealth they have accumulated over the years, through FX interventions, thus aggravating their external positions. It is reported that Asia spent $50 billion in September in their futile effort to stem the rise of the dollar against their currencies. Japan spent $13 billion. China and other countries did it too. China has a track record of burning almost a trillion dollars in their attempt to defend the renminbi in 2015-16. A return of the hawkish Fed is crushing prices of risk assets, too, even crude oil prices to a certain extent. While crude oil is still outperforming almost all other assets, it does not seem to be going through the roof, a prospect that seemed highly likely earlier in 2022. SWFs of oil producing countries are enjoying healthy inflows of funds lately, bouncing back from the doldrums they suffered in the last decade. Nonetheless, they are still far short of the roaring performances they boasted prior to the 2007-09 Great Recession. China’s current account surpluses sharply fell to healthy levels down from double digits in relation to the size of economy. The world is no longer awash with savings and free money, and this is going to affect global economy and financial markets for years to come. About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.
