Macro Moments Weekly: Shock, suspense and interest rates

There are two kinds of shocks in films. The first is the classic horror shock, where something or someone appears out of nowhere to threaten the viewer; this is the shock of surprise. The second is psychological horror of suspense, where the viewer does not know what is going to happen, and through the twists and turns of the plot hopes it does not happen, but eventually it does. Hitchcock was the master of the second kind.

Markets are confronted with the same twin choices when looking at events that shock. There is surprise, the event that jumps out of nowhere. These typically originate outside the financial world, with examples such as the COVID-19 pandemic or, too often in history, wars. Then there is the shock of suspense, those that are created within the financial system and grow and mature until they explode. We often describe these as investment bubbles, whether the cause is railways, mortgage loans or ‘dotcoms.’ These lead markets to have guilt, anxiety and most of all, prolonged involvement.

Is it possible for a surprise shock to the financial system to become a suspense shock? Logically, you would look at the impact of the two world wars in the 20th century to make such a case. But in those examples, as governments took over the economies in pursuit of the war effort, the winners experienced limited negative impact. Remarkably, during the ravages of the worst pandemic of the last 150 years—the 1919 Spanish flu—the Dow Jones Industrial Average rose. The end of the war was more important to markets. At the same time, the disastrous Treaty of Versailles was being written, which ultimately proved that rebuilding the vanquished was more important than celebrating the victor.

Clearly, this is the choice the markets face at this moment in time. Will the surprise shock of the beginning of the US-Iran war turn into a suspense shock of a longer financial crisis?

This week, the world’s leading central banks will hold meetings to set interest rates, and they will have to answer this question: Do they need to restrain the current shock of inflation? In 2022, a similar shock from the Russia-Ukraine war turned into suspense and created an interest-rate regime change.

In the current conflict, after almost two months of disruption to the world’s energy supplies, a 50% rise in the cost of oil and gas and 100% for jet fuel, Europe is feeling the war’s consequences. Lufthansa has cancelled 20,000 flights, consumer companies such as Next and Sainsburys have warned that the impact on profits is already visible, manufacturers have stocked up on supplies, expecting prices to rise, just as consumers have stocked up on fuel. Business confidence in Europe is falling sharply, especially in the service sector where ‘Business activity is falling at a rate not seen since the pandemic lockdowns of early 2021.’¹ For Europe, the US-Iran war is a worse shock than the Russian invasion of Ukraine.

But there is also evidence of a demand response: A sharp rise in the sales of electric cars and a fall in travel are two already visible alongside the cuts in growth forecasts by the International Monetary Fund and, notably, the German government. As demand falls, surely inflation should, too, but the experience of 2022 was that such logic only applied in the United States; there, the pass-through of inflation was fast and limited—a shock. In Europe it was prolonged and painful; it became suspense.

Leaving aside the fact that the European Central Bank and the United Kingdom’s Monetary Policy Committee do not have dual mandates (responsibility for stable prices and full employment), but the US Federal Reserve does, the logic of an interest-rate rise for Europe is clear. The logic for no rate rise in the United States is just as clear. The year 2026 is beginning to look like (another) lost year economically for Europe, but controlling the inflationary shock now could create the possibility of interest-rate cuts into a recovery in 2027. By raising rates, central banks could ensure the war is a shock, not longer-term suspense, and therefore equity markets could conceivably rally on such news; I believe bonds would be even more likely to.

Parting shot

I was lucky enough to present to a brilliant group of the next generation of City of London leaders this week. After all the global economics and forecasts, the question that dominated the reception was house prices. What was striking was that the only people who had already bought houses had bought them outside of London, confirming anecdotally this week’s data that central London prices will remain under pressure.