Troubles are coming to the world economy — not as single spies, but as battalions. They are doing so on multiple fronts, in the United States, China and Europe. Coupled with renewed geopolitical strains in the Middle East, those troubles heighten the chances of a full-blown world economic and financial market crisis by the middle of next year.
Among the greatest threats to the U.S. and world economic recoveries is the recent spike in U.S. Treasury bond yields, the key interest rate in the world economy. In the short space of two months, the 10-year Treasury bond yield spiked from less than 4 percent to over 4 ¾ percent — a 16-year high. It did so in response to Federal Reserve warnings that interest rates would stay high for longer to contain inflation, as well as to growing market fears about how the U.S. government will fund its budget deficit, at 8 percent of gross domestic product.
The sharp rise in interest rates has already sent the 30-year mortgage rate toward 8 percent and substantially increased the interest rate cost for automobile purchases. This must be expected soon to constitute a major headwind for both home and automobile sales at the very time when most households have run through their pandemic savings and the government faces another shutdown.
It is also likely to exacerbate problems in the commercial property space where property developers are already struggling with low occupancy rates in a post-COVID world. The last thing that these developers needed was to have to pay higher interest rates on the more than $500 billion in commercial property loans that come due over the next few years.
Worse yet, the spike in Treasury bond yields must be expected to soon lead to a U.S. credit crunch. It is likely to do so by raising solvency questions in large swaths of the U.S. banking system in general and the regional banks in particular.
Even before the recent spike in bond yields, it was estimated that the U.S. banking system had more than $600 billion in mark-to-market losses on its bond portfolio. The further plunge in bond prices is going to add substantially to those losses. This puts the regional banks in a particularly poor position to absorb the expected wave of defaults on their commercial property loan portfolios, which constitute almost 20 percent of their balance sheet.
It would never be a good time for the world economy to have China, the world’s second largest economy and until recently its main engine of economic growth, move to a decidedly lower economic growth path. It would be a particularly inopportune time for such an occurrence when the United States appears to be on the cusp of a meaningful economic recession. Yet that is what now seems to be occurring in the wake of the bursting of that country’s outsized housing and credit market bubble. The bursting of that bubble, coupled with China’s very poor demographics, is now raising serious fears that China is well on its way to a Japanese-style lost economic decade.
Similarly, now would seem to be an inopportune time for Europe to succumb to an economic recession and to experience another round of its sovereign debt crisis centered on Italy, a country with an economy some 10 times the size of that of Greece. Yet that now seems to be very much in prospect as the European Central Bank continues to raise interest rates to regain inflation control at a time of economic weakness, and when the Italian government has introduced an expansionary budget while its public debt level is very much higher than it was in 2012. The German economy has now already experienced three consecutive quarters of negative economic growth, as the spread between Italian and German bond yields is increasing at a troubling rate.
All of this would seem to have clear implications for U.S. economic policymakers. The Federal Reserve should back off its high interest rates for longer mantra and start preparing for a world economic and financial system crisis. At the same, Congress should get its act together and start addressing in a meaningful way the country’s long-term budget deficit problem.
American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.