Fork in the road: the world’s choice between a hard or crash landing

Surging inflation expectations threaten to send the world into a sovereign debt crisis, leaving central banks with a horrible choice: a hard or crash landing.

The Commonwealth Bank of Australia thinks inflation will hit 5.4 per cent by the middle of 2026 in Australia and the energy shock could create worse inflation elsewhere in the world.

This makes new borrowing for governments very expensive. In Australia, the Federal Government’s cost to borrow is at its highest since 2011. In the UK and Japan the energy price shock has pushed borrowing costs to their highest since the Great Financial Crisis.

“The longer the war drags on, the higher the oil prices rises and the longer supply of oil is restricted, the more of an economic disaster this could become,” said Schroders Australia’s Head of Multi Asset Investment, Sebastian Mullins.

Since the war began, emerging markets have seen the steepest increase in government borrowing costs. Alongside nations like the UK where expectations of interest rate cuts, before the war, were suddenly reversed to expectations of hikes.

On Friday, Mr Mullins warned. “We remain negative on duration. Now that inflation may be reaccelerating due to higher oil prices, this puts central banks in a bind.”

The strategist warns high inflation is a bond investor’s worst nightmare, as the value of future interest income is eroded away.

By stating that Schroders is “negative duration” he suggests it is likely a bad idea to hold bonds that will lose more value as inflation drives up the cost of debt.

Moreover, the shock from soaring energy prices leaves central bankers in a bind as they seek to combat inflation, without raising interest rates so high that they snowball an economic crash.

Central bankers know that the supply-side inflation shock delivered by the Strait of Hormuz’s closure cannot be solved by raising interest rates. Unless, you target complete demand destruction and a major recession such as that delivered by US Fed Governor Paul Volker over 1981 and 1982.

This means some economists now expect the Reserve Bank of Australia will deliver just one more interest rate increase in 2026 as the soaring cost of living slows the economy so much that the central bank does not need to apply the brakes harder.

Debt costs rocket

But any global debt crisis is far more likely to come from the emerging markets of Asia, or heavily indebted European economies.

Already, Iran’s neighbour Turkey is teetering on the brink of insolvency and suffering an inflation crisis as citizens and investors don’t want to hold the Turkish Lira out of fear its government’s loan promises will soon be worthless.

In 2022, Sri Lanka required an IMF bailout partly as a result of the interest rate cycle and energy price shock from Russia’s invasion of Ukraine.

In 2011, the last time yields this high in many countries, Greece became the first major European country to experience a shock on the scale of the 1930s Great Depression in the US when economic output fell as much as 30 per cent.

Back then, bond markets rightly viewed it as bankrupt and unable to pay its debts and enforced a punishing bailout of spending cuts that translated into mass unemployment.

That economic nightmare is what investors know the almighty bond markets can impose on nation states if they refuse to lend to them.

The bond markets are more likely to ignite a financial crisis related to the Middle East than share markets, which provide little guidance on the probability of a severe downturn.

One upside is that President Donald Trump, as a real estate and construction billionaire, understands the importance of low interest rates to a sound economy.

Further increases in US interest rates may generate more political pressure on the president to seek a peace deal than a share market correction from record highs and a three-year bull run.

As Westpac said on Friday. “Two potential paths are ahead for the world.” One is a negotiated peace in the Middle East sooner, rather than later. The other is a potentially cataclysmic blow-up as energy and inflation race even higher in tandem.