Updated: Apr 4, 2019
by InvestCEE Staff, Chris Ball
Link here to Part I - Explaining the Yield Curve
Link here to Part II - The Inversion and What It Means
In this final part to our short series on the Inverting of the US Yield Curve, we look at the implications for Central European economies. The short answer is that the inversion itself doesn’t necessarily affect Central European economies, but a potential US recession and resulting FED action can affect the region.
Our best understanding of why the US yield curve inverted is that market participants are expecting the US economy to slow in the coming 2 years or so. A slowdown on its own can lower interest rates as the return on investments declines and/or inflation slows. But the more important effect here is that the US Federal Reserve will likely act to lower interest rates in order to fight the recession. We’ll take each of these issues – a US slowdown and a FED interest rate decrease – in turn to think through the implications for the CEE region’s economies.
A US Economic Slowdown
A slowdown in the US will have two opposite effects on CEE economies. The first is the most obvious. The US has a large market for goods and services. A slowdown in the US means weakened demand for exports from Central Europe. It will directly lower demand and also indirectly by lowering demand for goods from CEE partner countries like Germany. This is the typical ripple effect. When the US sneezes, the world economies catch a cold. This lower US demand is a pure negative effect on the CEE economies.
The second effect is less obvious. As the US economy slows, returns to investments in the US fall and investors look around the world for other good investment opportunities. Good returns in Central Europe could attract global capital more easily during a US slowdown. This is a less direct, but positive effect.
All else equal, these two effects together can also lead to a slight strengthening of CEE currencies. This will depend on which effect is stronger, however. If the US slowdown dampens demand and drives world economies, including CEE economies, into recession, then all bets are off. Anything could happen to exchange rates. But, if the US slow down relative to CEE economies (i.e., doesn’t drag the CEE down so much), then we could see a slight strengthening in their currencies which strengthens their purchasing power in world markets.
A US FED Interest Rate Cut
If the US economy looks like it will slow, the US Federal Reserve will lower US interest rates in advance of the slowdown in an effort to prevent it. This will have two effects that are quite significant.
First, the indirect effect: Should the rate cuts succeed in avoiding a recession, this will limit the negative demand-side effects mentioned above.
Second, the direct effect: A US interest rate cut will definitely lower returns to US investments and encourage investment capital to flow into non-US markets. This benefits the CEE region by again, making investments in the CEE economies relatively more attractive than before.
All Else Equal
Economists love to say “all else equal” (as I did above), but things are rarely all equal. While we focused on the US slowdown alone, the rest of the world keeps changing. It will be important to watch for continued economic slowdown in China and for economic growth in Europe.
Eurozone economies are already slowing which in part prompted worries about a US slowdown (due to declining global – namely European – demand for US goods) and secondly has already caused the European Central Bank to lower its interest rate, pulling Eurozone rates into negative territory in an effort to stimulate Eurozone economies.
Overall, the US yield curve inversion tells us that market participants expect a US slowdown in the coming 2 years, but not today. The European Central Bank is stimulating the Eurozone economies with rate cuts and the US FED will stimulate the US economy with rate cuts if the economic outlook continues to darken.
Both these rate cuts encourage capital flows into the CEE region and that can actually be positive over the coming 12-24 months. The US economy doesn’t look set to worsen quickly. So the implications of the US yield curve are mild to mildly positive for the CEE region if anything.
The immediate danger for the CEE economies is a slowdown in the Eurozone. Germany is the biggest importer from most of the major CEE economies. Hungary and Slovakia both critically rely on a strong German car market as both countries have large parts of German automotive manufacturing supply chains in their countries.
The worst case scenario would be a worsening Eurozone economy combined with a hard and sudden US downturn, but that doesn’t look likely at this point. The US yield inversion is also mild. Again, it shows lower rates in 12-18 months for about 12-24 months, but positive rate growth again after that. Anticipation of a much deeper recession would imply yield inversion for a longer period.
For now the Central European economies look to be in good shape and should prove robust to the recently predicted effects of the US yield curve’s inversion.
About the author
Chris Ball, PhD is the co-founder and advisor for InvestCEE. Chris serves as the Honorary Hungarian Consul for Connecticut, the executive director of the Central European Institute and the István Széchenyi Chair in International Economics at Quinnipiac University.