Suddenly, financial markets have become highly volatile, with the escalation of Middle East hostilities and last week’s increased US inflation reading generating tension and uncertainty.

The US dollar is surging and creating dilemmas for central bankers elsewhere.

Stephen Bartholomeusz

GUSNOTE: THIS IS NOT SUDDEN... THE WRITING WAS ON THE WALL FOR A WHILE....

Oil prices, already above $US90 a barrel, could go higher and add to the challenges faced by economic managers, depending on how Israel responds to the weekend barrage of drones and missiles.

Gold prices are at record levels despite the strength of the US dollar.

The US CPI numbers, which saw the inflation rate edging up, sent shockwaves through markets.

The stock market fell almost 1.5 per cent and US bond yields spiked significantly – both 2-year and 10-year yields ended the week 16 basis points higher.

The US dollar jumped nearly two per cent against the basket of its major trading partners’ currencies

The Australian dollar was down more than one and a half US cents, dropping from US66.29 cents to US64.75 cents after the CPI’s release was interpreted as ruling out any near-term cut to US interest rates.

Where, at the start of the year, markets had factored in as many as six rate reductions by the Federal Reserve Board this year, now the most optimistic case is that there might be two. Some economists are ruling out any increase while Larry Summers, the former US Treasury secretary, says there might even be a rate rise.

It appears the impact of the Biden administration’s very loose fiscal policies in negating the effects of the Fed’s tight monetary policies and keeping US inflation rates at levels the Fed is uncomfortable with might have been underestimated.

The “high for longer” scenario that has now taken hold, and the US bond market’s response to the inflation data, means that the interest rate differentials between the US and other major – and minor – economies are widening.

Japan’s yen is now at a 34-year low against the dollar, the euro (which was already falling against the dollar) has depreciated further, by a fraction less than 2 per cent, since last Wednesday’s inflation data release.

China’s yuan has been edging down against the dollar all year, even though it is a “managed” currency. Emerging market currencies are under similar pressures – Indonesia had already been buying rupiahs and selling dollars to try to put a floor under its currency.

For central banks and economic policymakers whose economies are experiencing low growth and declining inflation, the dwindling prospect of lower US interest rates is a threatening complication.

The European Central Bank, for instance, has conditioned its markets to expect several rate cuts this year.

With the interest rate differentials already wide – the yields on 2 and 10-year German bunds are already more than 2 percentage points lower than those on their US counterparts – further divergence could spark capital flight from Europe as investors pursue the higher returns available in the US.

The Japanese, amid widespread speculation that the Bank of Japan will intervene to put a floor under the yen, face a similar dilemma.

In an economy that has experienced decades of deflation, the emergence of modest inflation (it was running at 2.8 per cent in February) was welcomed.

https://www.smh.com.au/business/markets/why-the-us-dollar-is-setting-off-alarm-bells-around-the-world-20240415-p5fjta.html

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