14 Dec 2023
Global Macro-economic Update – Interest Rates
As outlined many times in our newsletters, the macro-economic world entered a new paradigm in 2022. The supercharged asset price growth caused by 30 years of falling interest rates is now over, as stagflation through rising interest rates has taken hold. The era of free money is finished. Given the impact of rising interest rates across all sectors of the economy from mortgages rates to corporate loans, we thought that this newsletter should revisit some recent history to help understand the impact of rising interest rates across the globe. This may provide some insight into the future direction of interest rates globally, and Australia specifically.
Background: Inflation v Consumer Price Index
It is important to understand the difference and interrelationships between inflation and Consumer Price Index (CPI). Simply, inflation as Milton Friedman said is a monetary phenomenon and is a result of increases in the supply of money, i.e., money supply has grown faster than the demand for it, or it has grown faster than Gross Domestic Product (GDP). If money supply grows faster than demand, as has occurred since the Global Financial Crisis (GFC) and Covid lockdowns, then the consequences are inflation and loss in Purchasing Power (PP). Conversely, deflation is when money supply is falling faster than the demand.
CPI which the media incorrectly refers to as inflation is a result of demand/supply imbalances in goods and services, and that’s why it is called Consumer Price Index, not inflation. CPI is made up of a basket of products and services, and therefore the choice of those items that make up the index has a major impact on changes in CPI. For example, US CPI does not include food which is a life necessity, not a luxury which is arguably not correct, as we all know changes in food prices significantly affect household disposable income. Ask anyone about food and petrol prices and they will say they have increased significantly over the last 12 months and if their salaries are not increasing as fast as CPI, then they are losing PP, i.e., going backwards financially in real terms. Why do countries not include life’s necessities in CPI? We do not know. What we do know is that the components of CPI are changed so governments can manipulate the results. You may also ask why isn’t there a global standard? We agree there should be a global CPI basket standard.
What caused the CPI Increases?
As we are all aware that when Covid hit, governments across the globe shut down their economies by enforcing lock downs. People had to work from home, travel was banned and there was major disruption to everyday life. To prevent a global depression caused by government induced shutdowns, governments quite correctly implemented compensation schemes, e.g., in Australia there was Job Keeper and Job Saver, which were aimed at ensuring the economy continued to function, albeit on life support. These schemes had some fundamental flaws which is a separate topic, so we will not comment any further on those matters, rather we will focus on consumer and business behaviour. As expected, folks and companies either saved, spent, or did a combination of both with the government handouts. In many cases employees because they were not incurring weekly travel costs, lunches, and were unable to dine out and go to entertainment events had more funds to spend and governments encouraged expenditure. What many consumers and companies did not do because interest rates were near to zero was pay down their debt. This was an understandable mistake because in 2021 central bankers were saying that interest rates would not increase until 2024. How wrong were those statements?
This sudden increase in demand for products rather than services caused supply problems as many workers, especially in China, the manufacturing hub of the world, were locked down disrupting manufacturing and distribution channels. New cars were in short supply as demand could not be met, so the price of used cars jumped. At that time, we constantly heard the phrase “supply chain problems”. Even after the “West” re-opened China’s locks down continued meaning the demand/supply imbalances also continued. This period marked the start of the increases in CPI.
These demand/supply pressures continued with finished products, e.g. semi-conductor chips for cars and the Russia/Ukraine war brought about shortages in energy and food products. Adding to these shortages was the impact of US sanctions on China as major US corporations moved production to other countries or back to the USA, as well as the changes brought about by the transition from fossil fuels to renewables. Unlike the Russia/Ukraine war we do not believe the Israeli/Palestine conflict will have the same level of direct economic impact because neither Israel, nor Palestine are major producers of energy products or staple commodities.
Central banks manipulation of the bond market
To fund the Covid programs, governments had to borrow more funds from the market by issuing bonds (debt). Most Organisation for Economic Co-operation and Development (OECD) countries were already carrying high levels of debt and these Covid programs added to it. Western central banks and governments had not repaired their budgets and balance sheets caused by the major stimulus programs after the GFC in 2007/08. Creating further economic stress in the 12 years since the GFC, central banks in key economic zones of US, China, Japan and Eurozone used monetary policy tools to manipulate interest rates, e.g., yield curve control, quantitative easing, etc. distorting price discovery in bond markets. The US Federal Reserve breached its own charter when buying mortgage-backed securities and bond ETFs. The Bank of Japan bought both bonds and equities and became the dominant player in those markets. Simply, central banks effectively became the market as the rules went out the door. At that time and even to some extent today the substantive use of these tools has diminished the ability of central banks to influence their economies through nuanced monetary policies, rather than falling back on the blunt interest rate tool. Even worse financial market participants now believe central banks in the future will bail out markets.
With the benefit of having the world’s reserve currency, the US has been able to massively expand money supply in a very short period of time. US Federal Reserve reporting shows US Money Supply (M2) averaged USD5.1 trillion from 1959 until 2023, reaching an all-time high of USD21.7 trillion in July of 2022.This changed in 2022 with central banks responding to CPI increases and the over expansion in M2 started hiking their cash rates. The aim being to dampen demand by contracting M2 with consequential flow on impacts to consumer interest rates, e.g., mortgages, personal loans and credit card rates.
The manipulation of bond markets also distorted the credit risk premium which is the margin that is added onto the base lending rate, e.g., 10-year US treasury. Normally, lower credit rating corporates have a higher credit risk premium, and vice versa.
Price discovery in the bond became next to meaningless because of the aggressive activities of central banks. As noted above central banks became the market and crowded out normal debt raising and pricing. We are dealing with the consequences of this today.
US Government debt
For the 1st time in history Emerging Market (EM) debt has traded at lower yields than US treasuries. What does this mean? Simply, the bond market sees Greek Government Debt as less risky than US Government Debt. You may ask that can’t be right? Why? There are a range of reasons, however it boils down to the markets believe the US has too much debt, e.g., budget and current account deficits, their National Debt is USD33 trillion and increasing and it has trillions in unfunded off balance sheet liabilities, e.g. US pension funds and student loans. The world funds a lot of this US debt, and it is questioning whether it should continue to do so, at such low real yields, i.e. interest rates less than the inflation rate. Countries that historically have supported the US are questioning this strategy, as can be seen through the BRICs de-dollarisation position.
US historical approach to tackling inflation
In the early 1980s the US ran large budget deficits under President Reagan and US Federal Reserve increased interest rates, so the US dollar appreciated enormously hurting EM economies and inflation fell globally. Forty years later, US policy makers decided to adopt this strategy again. However, the economic situation is very different. The US Debt to GDP ratio in the 1980s was about 37%, whereas today its 120%.
In the 1980s, the effect was for foreign capital to flow into the US as investors saw the US as a safe haven to put their money. It also meant that the demand for US dollars increased as foreign companies that borrowed US dollars through the Eurodollar markets needed US dollars to pay their interest payments, as is the case today. However, today there is an important difference with rising US interest rates, foreign investors including governments already hold capital in the form of US treasuries, e.g., China holds about USD800 billion which is down by 40% from about 10 years ago. China has been reducing its holding of US treasuries because of US sanctions and this rate of decrease accelerated after the US froze Russia’s holdings because of its invasion of Ukraine. Unlike in the 1980s foreign investors are selling their US treasuries and using the US dollars they receive to pay their higher debt costs and/or are repatriating the funds back into their local currency.
Except the UK, all OECD countries, including Greece (rating of BBB-) bonds recently have been trading at lower yields than US treasuries. As mentioned above this is the 1st time in history that this has occurred. If you remember back to 2007-2009 Greece was broke. Bond investors were forced to accept losses (terminology used in the industry is “a haircut”) and the International Monetary Fund (IMF) and the European Union (EU) required Greece to introduce austerity programs before funding life lines would be available. This was just 15 years ago which shows how quickly things can change.
It is important to understand that as US debt has increased so have interest rates. Investors understand the strategy of inflating the real value of debt away by letting inflation run higher than interest rates, so they are seeking higher returns (equivalent or better than the inflation rate) to prevent loss of PP.
Arguments that interest rates will go higher!
What does all this mean and why we believe it’s important? America has twin deficits. The current account deficit of 3.2% of nominal GDP and budget deficit of USD1.7 trillion or 5.7% of GDP which is up from 3.8% for 2022. These deficits need to be funded. Putting aside “money printing” which increases M2 and leads to more inflation, if the US is unable to fund these deficits by growing GDP at a rate faster than its interest commitments and is also unable to attract enough foreign investors, then interest rates will go higher.
On the domestic side this is a delicate balancing act for the US Treasury and US Federal Reserve in keeping US GDP growing faster than interest payments without causing a recession or causing sustained inflation through monetary policy or fiscal stimulus. Baby Boomers retiring and structural changes in the workforce and productivity improvements from technology, e.g., artificial intelligence could mean unemployment may not increase to levels reached in previous recessions, adding pressure on central banks to increase rates further.
It is apparent that foreign investors are baulking at funding the US deficits without being compensated for the risk of loss in PP and other risks, including US sanctions or confiscation.
Arguments that interest rates have peaked and will fall!
Countering the reasons there will not be higher interest rates, is that the global economy is slowing, key yield curves are inverted and recently unemployment globally has ticked up, albeit below the levels reached in previous downturns. In 2024/5, $2 trillion in US corporate debt (as distinct from the Eurodollar market debt) will roll over from low fixed rates to higher fixed/variable interest rates. These increased interest payments will impact corporate earnings.
These factors indicate a recession may occur which the central banks are watching closely, and arguably interest rates have peaked.
USD: World reserve currency and interest rates
The impact on the US dollar, the world’s reserve currency and US interest rates is much harder to understand. There are important considerations:
The US economy continues to be the largest in the world, and when combined with the following points below it puts it in a unique position.
In the energy sector there is the petro-dollar. This term is used to describe the arrangement where the US guaranteed Saudi’s security in return for selling oil only in US dollars. As discussed in earlier newsletters the petro-dollar is under attack with Saudi now selling oil to the Chinese in Yuan.
Global trade continues to be primarily in US dollars; however, BRICs is encouraging bi-lateral trade in local currencies and the move away from the US controlled SWIFT system, as part of its de-dollarisation strategy.
The US dollar dominates the Eurodollar market, which is where corporates raise US dollar debt through the debt capital markets. The size of this market is unknown, as it is not regulated by the US Federal Reserve or any other central bank. Estimates are that this market is between 1/3 to 3 times the size of the US domestic bond market.
All currencies are quoted against the US dollar. The impact of a stronger/weaker dollar flows through to all economies. The DXY index is the best measure of the strength/weakness of the USD against the basket of major currencies; however, it is important to understand that it is always relative.
Financial Markets are much more sophisticated than even 20 years ago, and money moves very quickly when governments try and impose financial repression through regulations.
US dollar debt is the only true global capital market as it is deep, liquid and built around securities (collateral). Whereas, the Yuan and Euro debt markets are primarily bank lending markets which lack liquidity. The Japanese capital markets are domestic and again does not compete internationally with the liquidity of the US dollar.
Changes in the geo-political landscape with the emergence of China and India as economic power houses challenging the US dominance; however, there is no real rival to the US dollar.
Important take aways
Higher interest rates make investment more expensive, so investors are wary of tying their money up for long periods of time. Understandably, they prefer liquidity.
Modern Monetary Theory has been discredited as inflation broke out which the theory postulates would not occur.
Investors will not accept real negative yields as central banks attempt to float the real value of debt away.
Governments are always incentivised to accept inflation over unemployment, because inflation reduces the real value of debt and impacts everyone, whereas unemployment affects a few although it may have longer term social issues and budgetary costs.
Governments will always support the bond market over its currency.
The US Federal Reserve at any sign of disruption to the financial system will flood the markets with liquidity by intervening in the debt markets.
The US Federal Reserve since Chairman Powell took over appears to be committed to returning to its mandate of 2% target for inflation and ending the so called “Fed Put”.
There is no real rival to the US dollar, so holding US dominated assets continues to be a safe investment strategy.
The US Federal Reserve monetary policy continues to dictate global interest rates.
The impact of the new paradigm of higher interest rates has a long way to play out, as after a 30 year period of falling interest rates adjusting to the new world does not happen quickly when the macro-economic and geo-political environment is also changing.
The US, Australian and NZ housing markets have turned, as higher interest rates are starting to hurt.
In the days and months ahead, we recommend watching closely unemployment figures (lagging indicator), CPI (lagging indicator), retail sales (leading indicator), global trade figures (lagging indicator), Money Supply (lagging indicator), Purchasing Managers Index (leading indicator), fiscal expenditure as a percentage of GDP (lagging indicator), and US treasuries (leading indicator), as these will provide signals as to the likely direction of US interest rates which will flow through to Australia. These are unchartered waters!As always, we are available to discuss investment and debt strategies, so please feel free to reach out.
As with previous years, even though the office will be closed over the Christmas break, we will be monitoring emails.
General Advice Warning: Any advice or information provided is general advice only and has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any General Advice provided, you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. If you wish to discuss the contents of this newsletter, please do not hesitate to contact us.