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As 2023 comes to an end, consensus forecasts suggest that a soft landing for the US and other global economies is ahead, leaving implied volatility in equity and currency markets plumbing lows last reached just before the pandemic hit in 2020. But the laws of economic gravity have not been repealed. The aftereffects of the largest increase in borrowing costs in more four decades are only beginning to make themselves felt; the changes unleashed by the pandemic are still reshaping fundamentals; and policy uncertainties are set to rise as the US election cycle nears completion. We expect a series of dislocations to take place in financial markets through the course of 2024 as the global economy breathes increasingly rarefied air.

Disinflationary forces are growing more powerful.

The global inflation shock is fading fast. After soaring for the better part of two years, food- and energy-driven headline price measures are coming down more quickly than expected, and core inflation rates (i.e., excluding food and shelter) have tumbled across all major developed economies.

With supply chains now largely repaired, Western consumer demand slowing, and the Chinese government pouring stimulus into the manufacturing sector, prices are falling for internationally-traded goods. At the same time, a weakening global demand outlook is intersecting with surging non-OPEC production to put oil benchmarks – critical in driving consumer inflation expectations – under sustained pressure.

Producer price indices measures, annual % change

Most of the major industrialized economies are showing signs of slowing. Although wages are beginning to outpace inflation in many countries, real household purchasing power remains weaker across most income strata. Excess savings, accumulated during the pandemic, have largely evaporated, and consumers are increasingly tapping sources of credit to sustain spending. The legacy of this year’s sharp rise in borrowing costs is still hitting household and corporate balance sheets, and the flow of money through domestic financial systems is slowing almost everywhere.

Money supply measures, annual % change

With the balance of inflation risks swiftly tilting to the downside, markets expect central banks to begin normalizing policy settings in the coming months. Federal Reserve Chair Jerome Powell’s comments during a mid-December post-decision press conference were widely read as implying a willingness to follow canonical policy guidelines—like the Taylor Rule—in moving even before evidence of a downturn arrives. Further, Fed Board Governor Waller’s late-November comments—in which he explicitly said reducing rates would have “nothing to do with trying to save the economy or recession”—have helped ratify market expectations for a fast and furious cutting cadence. The European Central Bank’s Isabel Schnabel, Huw Pill at the Bank of England, and even the Bank of Canada’s Governor Tiff Macklem. have hinted at easing ahead.

Market-implied expected change in policy rate, %

Long-term yields have fallen precipitously from their October highs; asset prices are nearing post-pandemic peaks; and a range of financial conditions indices – which attempt to measure the cost and availability of money in the economy – are back in accommodative territory.

G7 gross domestic product-weighted financial conditions index

Real rates could remain relatively restrictive.

Given the significant progress seen thus far, it would take a meaningful re-acceleration in price growth to motivate additional interest rate hikes in major economies, and a deep downturn could force central banks into delivering the easing currently priced into markets.

But because inflation has fallen in line with policy expectations, real interest rates remain elevated, and could ultimately settle well above pre-pandemic levels as the world grapples with changing demographics, geopolitical uncertainties, extraordinary levels of indebtedness, deepening capital scarcity, and higher long-term volatility risks. For households, businesses, and governments, the extremely demand-stimulative borrowing environment that prevailed for more than a decade now looks like a temporary aberration.

Real 10-year bond yields, %

Regional divergences are growing more likely.

The global adjustment to higher borrowing costs is just beginning, and we think it will likely be more painful for some than others. Across developed economies, households and businesses are struggling under a mountain of debt that will, in many cases, only get heavier and more destabilizing in the year ahead.

Private non-financial sector debt service ratios, %

Exposures vary across countries, and structural differences complicate cross-national comparisons. But we think the United Kingdom bore the brunt of tightening early and could move through the low point of the economic cycle relatively quickly, given a lower starting point in private sector debt service ratios. The euro area’s pain could be more prolonged, with France picking up the baton from export-focused Germany in experiencing a downturn. Canada and Australia, with much higher levels of indebtedness, financial systems dependent on short-term mortgage vehicles, and economies heavily reliant upon real estate-related activity, could suffer the worst – with an Australian caveat potentially coming from the country’s relationship with a more stimulative China.

Resilience in the US has bolstered hopes for a soft landing that leaves financial markets and the real economy relatively undamaged. Global interest rate trajectories have converged, and long-term yields have dropped in line with signs of slowing inflation. The People’s Bank of China has kept a tight leash on the renminbi, while the Bank of Japan’s intervention threat has capped losses in the yen. A slowdown in the euro area has restrained the common currency’s gains against the dollar.

Except for Treasury futures—which have been roiled by shifting views on inflation, underlying growth, fiscal funding gaps, and changing Fed policy—trading ranges have subsided across a range of asset classes. Foreign exchange traders seem particularly unworried, with implied volatility in many currency pairs plumbing historic lows last reached just before the pandemic hit in 2020.

Implied volatility indices, z-scores

We very much doubt this state of affairs will last. Relationships between asset prices and economies remain riven with contradictions. Growth trajectories seem likely to diverge more fundamentally in the year ahead, and yield differentials are unlikely to remain stable. Volatility will return, and with it, big moves in currency markets.

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