Is the global economy about to topple?
Will the current dizzying oil price and bond yields, is the global economy near to tipping over?
In the macro realm, bad things usually come in pairs. The confluence of yet another surge in oil prices and a long-overdue back-up in bond yields has piqued my interest in that regard. Crude oil prices are back near $70 and bond yields are at important thresholds -- closing in on 2% in Japan, 4% in Europe, and slicing through 5% in the US. My concerns stem less from a partial analysis of each development and more from the potential interplay between them. The combined impacts of these two factors raise the odds that a tipping point for an unbalanced global economy could well be close at hand.
I continue to believe that the American consumer is the weak link in the global daisy chain. The combination of rising long-term interest rates and higher oil prices puts an unmistakable squeeze on discretionary income -- the last thing overly-indebted, saving-short US consumers need. The higher gasoline prices arising from the recent back-up in crude oil markets unleashes a classic negative income effect on the consumer that, by Dick Berner's reckoning, could knock about $60 billion, or 0.6%, off disposable personal income this summer (see his dispatch in today's Forum, "Risks for the Consumer"). At the same time, higher US bond yields could unleash a negative wealth effect -- taking a toll on a housing market that is already moving lower and also acting to constrain mortgage refinancing activity and household sector equity extraction. For a US consumer who remains chronically short of labor income but who drew support from more than $600 billion of annualized equity extraction in late 2005, that could be an especially tough blow.
In this increasingly interconnected global economy, America's problems quickly become the world's problems. Other consumers will also feel these impacts -- albeit to a varying degree, depending on their sensitivity to oil prices and interest rates. But the US, as the world's heretofore most resilient and dominant consumer, could well be the lightning rod for a broader array of global impacts. The combination of negative income and wealth effects is not only a double whammy for the American consumer, but it could also be an equally tough blow for the global producer. Trade linkages will quickly bring America's rapidly expanding external supply chain into the equation, especially the top three exporters to the US -- Canada, China, and Mexico. Collectively, these three countries accounted for fully 42% of total US imports in late 2005. But it would also be the case for the next tier of America's import sourcing -- Japan, Germany, the UK, and Korea -- which collectively account for another 20% of US imports. With America's imports of tradable goods currently standing at a record 37% of goods consumption, any pullback in US discretionary spending spurred by the confluence of income and wealth effects could have very powerful global ripple effects.
Trade impacts should not be measured solely on the basis of who ships the most to the US. Equally important is the export dependency of America's suppliers. On that count, China's exposure is especially worrisome. Exports currently account for nearly 35% of Chinese GDP, and of that amount, fully 40% go to the US. China is also heavily exposed to oil. Its oil consumption per unit of GDP is literally twice that of the average developed economy. While a subsidy structure limits the direct impacts of higher oil prices on Chinese consumers, that simply means the pressures bear more on the fiscal finances of the central government. Consequently, the confluence of rising oil prices and bond yields hits China with a double whammy of its own. Needless to say, if that leads to a slowing of Chinese economic growth -- an outcome that is also consistent with the objectives of the government's latest five-year plan -- collateral damage on China's major trading partners would be expected. That would especially be the case for its Asian neighbors such as Taiwan, Korea, and Japan. Participants in China's new and increasingly far-flung commodity supply chain would also be affected; that would include Brazil, where exports to China have increased five-fold since 2000, and Australia, where the growth in Chinese exports has accounted for fully 34% of the cumulative increase in overall exports since 2000. Globalization cuts both ways -- it reinforces trade-dependent growth on the upside but also exacerbates adjustments on the downside.
Still, there is another channel of macro transmission effects that must also be considered in sorting through the combined impacts of rising oil prices and bond yields -- the global liquidity cycle. World financial markets have drawn extraordinary support from the unusually accommodative monetary policies of the world's major central banks over the past five years. This has played a key role in driving the global property boom, which has benefited a broad array of economies around the world -- especially the US, the UK, Spain, Australia, and New Zealand. At the same time, the developing world has also benefited from this powerful upsurge in the global liquidity cycle; emerging market debt and equity have led the charge in the global asset performance sweepstakes over the past three years. This has enabled developing countries such as Mexico and Brazil to ride the tailwinds of falling interest rates and all but eliminate their foreign indebtedness. Needless to say, this has been a truly liberating experience for economies long buffeted by all-too-frequent crises.
Yet what central banks giveth, they can always taketh. All three major central banks the Federal Reserve, the European Central Bank, and the Bank of Japan are now on the tightening side of the policy equation, the first time they have been collectively engaged in taking away the global punch bowl in about 15 years. The Federal Reserve has raised its policy rate in 15 consecutive meetings of the Federal Open Market Committee. Unlike the Fed, which may now be nearing its ultimate objective, the ECB and the BOJ have only just begun the process. Thus far, the impacts of this policy normalization campaign have been largely confined to the short end of the yield curve -- thereby having little bearing on those segments of real economies, such as homebuilding, capital spending, and consumer durables, that are more sensitive to rates at the longer end of the maturity spectrum. The recent back-up at the long end of global yield curves underscores the growing risk of a serious challenge to that immunity.
To the extent the normalization at the short end of the global yield curve is finally accompanied by normalization at the long end, a decisive turn in the global liquidity cycle could well be in the offing. Rising oil prices could compound the problem. The oil-related hit to discretionary incomes of oil-consuming nations is the functional equivalent of an added withdrawal of excess liquidity in a world that is now on the other side of the monetary policy cycle. This underscores what I believe could well be the thorniest aspect of the outcome -- the potential nonlinearities of the interplay between a turn in the liquidity cycle and rising oil prices.
This is where macro is at its weakest. We are trained in the art of partial analysis. We have rules of thumb that are helpful in gauging the impacts of fluctuations in oil prices. We have different models that attempt to assess the impacts of swings in interest rates. But we lack a unifying "general equilibrium" framework that pulls it all together. Sure, Nobel Prizes have been awarded to brilliant theoreticians, such as Stanford's Kenneth Arrow, for making important progress in deepening our understanding of the conceptual context of this problem. Large-scale econometric models have also been designed to deal with so-called spillover effects from one sector to another -- in some rarer cases, from one country to another. But these tools just don't cut it in today's Brave New World. Liquidity cycles and asset bubbles have gone to excess, while oil prices are in uncharted territory. Meanwhile, the globalization of trade and capital flows has redefined the cross-border linkages that will ultimately shape the outcome. Sadly, we are better equipped to deal with the macro of yesteryear.
I am coming around to the view that nonlinear "threshold effects" -- the macro equivalent of the tipping point -- will probably play an important role in unmasking the endgame in today's liquidity-driven unbalanced world. The breaking point in this case will probably be determined by a combination of economic and psychological factors. That's because the sustainability of America's current account deficit -- by far, the most serious imbalance in today's unbalanced world -- is critically dependent on the confidence that foreign investors place in dollar-denominated assets. If that confidence were to falter for any reason, the subsequent venting of the pressures stemming from the massive US external deficit may be swift and severe -- with important spillover effects on other markets and wealth-dependent economies around the world.
I honestly don't know if the bond market and oil prices are now at thresholds that could spark such pyrotechnics. I suspect it could take something more in the 5.5% to 6% range for yields on long Treasuries to qualify as a full-blown tipping point. Even so, a 5% bond yield and $70 oil are much closer to that possibility than has been the case in a long time. Moreover, it's important to note that this confluence of forces is not occurring in isolation -- it is playing out in the increasingly ominous context of a post-US-housing bubble shakeout and an increase in protectionist pressures.
Courtesy of a more-than-ample cushion of excess liquidity, an unbalanced global economy has endured an extraordinary array of destabilizing developments in recent years. This had led to excesses in many segments of world financial markets -- especially in some of the riskiest markets, such as emerging-market debt and equities. Investors are now taking liquidity-induced resilience in the global economy for granted. Maybe Iceland was the canary in the coal mine after all.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum.