When America sneezes, the world catches a cold – as the old saying goes.
It's only been two years since the COVID-19 pandemic began, but economists are already speculating about when the next recession could happen.
The United States will fall into recession in late 2023 because its central bank, the Federal Reserve, will hike interest rates too quickly, Deutsche Bank is predicting.
"We no longer see the Fed achieving a soft landing," Deutsche Bank economists led by Matthew Luzzetti wrote in a report to clients.
"Instead, we anticipate that a more aggressive tightening of monetary policy will push the economy into a recession."
Another major bank, Goldman Sachs, is forecasting a 35 per cent chance of a US recession in the next two years.
'Significant' risk of hard landing
With increases to the cost of living surging to a 40-year high in America, there's a strong argument that the Fed now has to rapidly hike rates to cool the economy down.
Money markets are betting the Fed will announce outsized rate hikes (0.5 of a percentage point) at its next few meetings – and that its benchmark interest rate will soar to 3.2 per cent in a year's time.
That's an extraordinarily rapid pace when you consider that US rates are currently near record lows (between 0.25 and 0.5 per cent).
"The Fed doesn't have a great history in terms of interest rate hikes," AMP Capital senior economist Diana Mousina told ABC News.
"There is definitely the risk that this time round inflation is so elevated in the US, and the economy is running so hot, that the Fed may think it's way behind the curve and take interest rates too high.
"When you see a big downturn in the largest economy in the world, there's obviously negative impacts for major trading partners like Australia in terms of lower demand for exports – so it does create a downturn in global trade.
"But in the short term, I think that there is still further upside for the US economy and for share markets as well."
The recession predictor
Wall Street has been particularly volatile since the end of March on the back of recession fears – with the Nasdaq, S&P 500 and Dow Jones dropping by as much as 9, 5 and 3 per cent respectively.
The source of this panic was a recession signal from the US government bond market, and a relatively rare phenomenon called the "inverted yield curve".
Basically, it's when you lend money to the government and get paid a higher interest rate for short-term loans (two years, for example), and a lower rate for long-term loans (10 years, for instance) – as shown by the downward-sloping "inverted" line in the RBA's graph.
In a healthy economy, it should be the other way around – where you earn more interest from riskier, longer-term lending (as shown by the upward sloping "normal" line).
That's because the longer you lend someone money for, generally the higher the risk of them not repaying all of it, or inflation or interest rates rising in the meantime.
An inverted yield curve means that traders are expecting the interest rate on US government bonds to fall in the future – probably because its economy is in, or has gone through, a downturn or recession.
Stock traders follow what's happening on the US government bond market very closely. That's because bond trading has been used to reliably predict every US recession since 1980.
The following graph shows all the occasions when the yield curve "inverted", and investors were paid more for two-year bonds compared to 10-year bonds.
Each time it happened a recession followed within six to 24 months.
However, the recession in 2020 was a coincidence, as no bond trader could possibly have predicted that a pandemic would happen and cause a global meltdown.
Recession risks growing in Australia
Money markets are betting that Australia's cash rate will surge above 3 per cent by the end of next year.
Considering the cash rate target is currently 0.1 per cent, that would mean a dozen rate hikes over the next year-and-a-half.
Whether the US economy falls into recession or not, Australia has its own problems to deal with.
The Reserve Bank recently forecast that if it were to lift rates by 2 per cent, property prices could drop by a massive 15 per cent.
A fall of that magnitude would certainly make consumers feel a lot poorer – causing them to cut back on spending, and therefore slowing down the economy.
"I think there's a pretty decent chance of Australia going into recession," said Angus Coote, co-founder of Jamieson Coote Bonds.
"One of the things that certainly worries me about the Australian economy is that we've got a tremendous amount of people that wisely took out fixed rate loans at very low interest rates, sub-2 per cent.
That's why some economists believe the RBA will only hike rates gradually (compared to the US, New Zealand, Canada and many other central banks).
However, the danger is if the RBA does not hike rates quickly enough, inflation could surge even higher, especially as the Australian dollar sinks.
If that situation were to arise, Australia's central bank might have to follow the US's lead, by hiking rates aggressively – risking a "hard landing" and another economic downturn.
