News of the week summary - 15/12/2024

China adopts “moderately loose” monetary policy to counter deflationary risks

For the first time in 14 years, China’s leadership has shifted its monetary policy stance from "prudent" to "moderately loose," signaling a major pivot in addressing the country's economic challenges. This highlights a commitment to implementing more aggressive fiscal and monetary measures to combat deflationary pressures and stimulate domestic demand.

This policy shift comes amidst ongoing economic struggles, including a sluggish property sector and weak consumer spending. The government's statement emphasized the need for "extraordinary countercyclical adjustments," meaning unconventional measures to offset the downturn, as well as efforts to boost consumption, improve investment efficiency, and expand domestic demand. 

Markets responded positively, with China’s 10-year bond yields hitting a record low of 1.92% as bond prices soared, and Hong Kong’s Hang Seng China Enterprises stock index rising by 3.14%. Lower bond yields generally reflect investor confidence in government-backed measures, though some warn of a potential “bubble” in government bond prices.

China's economy has recently teetered on the brink of deflation, as seen in November’s consumer price index rising by only 0.2% year-on-year—far below market expectations. Deflation, a sustained decline in prices, can exacerbate economic slowdowns by reducing corporate profits and discouraging investment and spending. To counteract this, the government previously introduced monetary and fiscal measures, such as tackling local government debt. 

This latest shift in policy mirrors a similar “moderately loose” stance adopted in 2008 during the global financial crisis. The change is viewed as a sign that Chinese authorities are prioritizing demand-side measures, particularly consumption, over supply-side reforms like innovation and supply chain upgrades. While the announcements signal determination, uncertainty remains about the implementation and effectiveness of these policies.

China’s economic performance in the coming months will hinge on how these monetary and fiscal strategies translate into tangible improvements in consumer sentiment and domestic demand. For now, the shift marks a critical acknowledgment of the challenges facing the world’s second-largest economy.

Rising government debt threatens global economic stability

The Bank for International Settlements (BIS), which advises central banks worldwide, has issued a stark warning about the growing risks posed by surging government debt. Claudio Borio, head of the BIS’s monetary and economic department, described sovereign borrowing as one of the most significant threats to the global economy and financial markets. He urged policymakers to act before financial markets react to unsustainable debt levels, cautioning that waiting for markets to "wake up" could result in severe consequences.

Global public debt is projected to surpass $100 trillion by the end of 2024, with borrowing nearing 100% of global GDP by the decade’s end, according to the IMF. Rising costs associated with managing this debt are already apparent. For example, the cost of insuring against a U.S. Treasury default has recently spiked, and France’s borrowing costs now exceed those of Greece—a stark reflection of market concerns. In Brazil, the currency has hit a record low due to fears over the nation’s growing fiscal deficit, despite promises of fiscal discipline.

In the U.S., the federal budget deficit reached $1.8 trillion in the fiscal year ending September 30, equivalent to 7% of GDP—nearly double the historical average. The unique status of the U.S. dollar as the global financial system’s anchor currency gives the U.S. some leeway. However, Borio warned that when concerns about U.S. debt sustainability eventually surface, the consequences could ripple strongly across the global financial system.

Paradoxically, despite these mounting debt concerns, equity markets remain buoyant. The S&P 500 continues to hit record highs, reflecting investor optimism about the near-term economic outlook. The BIS attributes this to a sense of economic stability and clarity following the U.S. presidential election.

While financial markets may appear calm, the warning from the BIS highlights the disconnect between optimistic market sentiment and the structural risks posed by escalating debt levels. Failure to address these risks could leave global economies vulnerable to severe financial turbulence in the future.

U.S inflation rises to 2.7%

Inflation in the U.S ticked up to 2.7% in November, according to the Bureau of Labor Statistics, matching Wall Street forecasts. This marks an increase from October’s 2.6% rate and supports expectations for a Federal Reserve interest rate cut next week. Markets are pricing in a 98% probability of a quarter-point cut, which would lower the target range for interest rates to 4.25–4.5%.

The Federal Reserve’s decision is shaped by its dual mandate: maintaining inflation near its 2% target while ensuring a robust labor market. The Fed has hinted at a slower pace of cuts in 2025 as it seeks to balance risks of persistent inflation and rising unemployment.

Monthly inflation figures showed a 0.3% increase for both headline and core inflation (which excludes volatile food and energy prices), driven primarily by housing costs. Annual core inflation rose to 3.3%. Meanwhile, services inflation slowed slightly to 0.2%, offering a hint of moderating price pressures.

Financial markets responded optimistically to the data. The S&P 500 gained 0.9%, and the Nasdaq surged by 1.75%, reflecting investor confidence in the Fed’s approach. Treasury yields, which move inversely to bond prices, edged lower, with the two-year yield slipping to 4.12%.

Global dynamics add complexity to the Fed’s strategy. Tariff threats from President-elect Donald Trump, including proposed 25% tariffs on Canadian imports, are raising uncertainty. Janet Yellen, the U.S. Treasury Secretary, warned that such tariffs could derail inflation control efforts. Meanwhile, the Bank of Canada cut interest rates for the second consecutive meeting, highlighting the challenges central banks face in navigating trade disruptions.

ECB cuts rates to 3% 

The ECB reduced its benchmark deposit rate by 0.25 percentage points to 3% yesterday, marking its fourth rate cut since June. The move reflects growing concerns about weaker-than-expected growth in the Eurozone and heightened global economic risks.

The ECB revised its GDP growth forecast for 2024 down to 1.1% from 1.3%, with projections for 2026 and 2027 also lowered to 1.4% and 1.3%, respectively. ECB President Christine Lagarde attributed these adjustments to mounting downside risks, including potential fallout from U.S. president-elect Donald Trump's proposed tariffs of up to 20% on imports. While these tariffs are not yet factored into the ECB’s baseline forecast, their implementation could further weaken the export-dependent Eurozone economy.

Lagarde revealed that some rate-setters had initially advocated a larger 0.5 percentage point cut but ultimately reached unanimous support for the quarter-point reduction. The ECB also adjusted its policy stance, dropping its commitment to keeping rates “sufficiently restrictive for as long as necessary.” Instead, it emphasized that the restrictive effects of monetary policy would "gradually fade" over time.

The ECB signaled the potential for further rate cuts but stressed that the pace would be assessed on a meeting-by-meeting basis. While inflation remains above target, rate-setters believe they are "on track" to achieve the 2% goal sustainably. Headline inflation is projected to hover around the target, at 2.1% in 2025, 1.9% in 2026, and 2.1% in 2027.

Markets anticipate the ECB will lower rates to 1.75% by September 2024, significantly outpacing the rate cuts expected from the U.S. Federal Reserve.

Germany faces economic stagnation in 2025 

Germany's Bundesbank has significantly downgraded its 2025 economic growth forecast, projecting just 0.1% GDP growth. This marks a sharp decline from its previous estimate of 1% and raises concerns about Europe’s largest economy facing continued stagnation or even recession.

The Bundesbank warned that Donald Trump's proposed tariffs—10% on European goods and 60% on Chinese exports—could exacerbate Germany’s struggles, potentially reducing GDP growth by 0.6 percentage points in 2025. If these measures are enacted, the German economy could shrink by up to 0.5%, plunging the country into a technical recession.

This pessimistic outlook aligns with the European Central Bank’s recent downward revisions for Eurozone growth, which also reflect concerns over trade disputes and global economic uncertainty.

Germany's prolonged economic stagnation has fueled public dissatisfaction, prompting snap elections in February. Policymakers face mounting pressure to address not only the near-term cyclical downturn but also structural barriers to growth, such as energy transition challenges and demographic shifts.

The Bundesbank predicts a modest recovery in 2026, with GDP growth forecast at 1.1%, a downgrade from its previous estimate of 1.6%. However, the recovery trajectory remains uncertain, especially if global trade tensions persist.