The world economy has an ominous August 2007 kind of feeling
August 2007 was, on the surface, a fine month for the U.S. and global economy. Unemployment was low. The stock market had a few bumpy days, but nothing too dramatic.
Why it matters: Many consider it to be the beginning of what we now call the global financial crisis. And there are some ominous parallels with what the world is experiencing right now.
- To be clear, we're not predicting a new crisis as severe as the one that rocked the world in 2008. Rather, we're arguing that major (and accelerating) underlying shifts are underway and likely to reverberate for years.
- How significant the pain will be is hard to predict. It could vary significantly across countries and industries. It's plausible that the economic damage in most sectors of the U.S. economy will be mild.
In this parallel, the tumult in Britain — where the currency and government bond prices are plunging — is the equivalent of when French bank BNP Paribas experienced funding problems due to mortgage losses.
- The bank required a liquidity lifeline from the European Central Bank on Aug. 9, 2007, which many date as the beginning of the global financial crisis.
- As it was then, the U.S. economy remains strong, and the financial disruptions across the Atlantic seem remote. But in that episode, they were in fact early manifestations of profound adjustments that were only beginning, and would eventually affect economies worldwide.
State of play: For a decade-plus after the 2008 crisis, the world was stuck in a low-interest rate, low-inflation, low-growth rut.
- Central banks searched for novel ways to loosen monetary policy to stimulate demand, including negative interest rates and quantitative easing.
- They concluded that the "neutral rate" of interest had become much lower, due to seismic forces like demographics and globalization.
- The widespread view — reflected in bond prices and officials' comments — was that after the pandemic's disruptions passed, this low-rate normal would return. Until recently, at least.
What's happened in the last few months — and with dizzying speed in the last several days — is that markets are adjusting to the possibility that the era of extremely low rates and liquidity is over, and the 2020s will be very different from the 2010s.
- Consider that at the start of the year, a 30-year U.S. Treasury bond yielded 1.92%. That's up to 3.62% as of 10:45am EDT this morning.
- The effects of that repricing are only beginning to ripple through the economy. It's most visible now in housing, but could eventually affect everything from the sustainability of large budget deficits to the viability of any business relying on lots of leverage.
Flashback: Donald Kohn, who played a key role in fighting the global financial crisis as the No. 2 official at the Fed, had some prescient comments last year.
- "It's possible that [the natural rate of interest] is higher than backward-looking models now suggest," he said at the 2021 Jackson Hole symposium, noting loose fiscal policy and pent-up savings.
- "But the transition to a higher rate environment could be pretty bumpy given that a lot of asset values and assessments of debt sustainability are built on very low interest rates for very long."
What they're saying: In a note out this morning, Joseph Brusuelas, chief economist at RSM, said that dollar funding markets have shown some of the strains they have in crises past (though not as severe.).
- He writes that it is likely economies that have been "characterized by insufficient aggregate demand and low inflation over the past two decades, will now be characterized by insufficient aggregate supply, negative supply shocks, geopolitical tensions and higher inflation," which require different monetary and fiscal policies.
- "Fixed income markets are signaling a shift in perceptions of financial stability and raising a caution flag for investors," he added.
The bottom line: We're in the early days of seeing how a world of tighter money will play out across sovereign nations, real estate, the corporate sector and more.