Since the 2008 financial crisis, unprecedented accommodative monetary policy was implemented by the FED. In December 2015 and 2016, the Central Bank increased interest rates twice. It was a false start in the normalisation of the curve. With the election of Donald Trump and a more expansionist budgetary policy coming, the potential return of inflation and a FED’s balance sheet equivalent to 25% of the U.S economy, a new cycle of rising interest rates is likely to start the next week. The speed and the spread of this movement are difficult to quantify yet. However, this dynamic is going to affect any investment. The purpose of this note is to highlight the risk attached to this.
For much of the period since the 2008 global financial crisis, the financial sectors have been able to rely on central banks to repress financial volatility and boost asset prices, supporting liquidity for a higher growth and faster balance-sheet repair.
To do so, the FED lowered interest rates down to zero and put in place a monetary policy called Quantitative Easing (QE). In this unconventional monetary policy, the Central Bank creates a new money to buy bonds or other financial assets to stimulate the economy by injecting liquidity. In theory, an increase of liquidity creates inflation, lowers the value of debt and brings up growth.
The FED implemented similar policies during the Great Depression in the 1930s. However, the scope of the QE program used after the 2008 crisis is unprecedented. As a result, the FED balance sheet holdings reaches $4.5 trillion or about 25% of the U.S GDP.
In December 2015, the FED announced the first increase in interest rates of a 25bp following by a second in December 2016, bringing interest rates to 0,50%; this level is accommodative still.
The economy is running at full employment; inflation is started to show some signs of increase and the Central Bank is under pressure to come back to a more conventional monetary policy.
Besides, the new Trump administration aims to support the economy using the budgetary weapon involving deregulation, infrastructure investment plan and tax reform. Most of these measures are going to be inflationary and the need of an accommodative monetary policy is evaporating.
The risk of interest’s rate hikes
First of all, a new cycle of interest rates hike will increase borrowing cost, and it will have an impact on consumption which represents two-third of the U.S. growth. How many increases can the U.S. economy absorb without damaging growth and employment, it is a question mark.
Second, the dollar is a particular source of worry for U.S. policy makers, which has appreciated 23% since mid-2014 against a basket of ten currencies. An increase of interest rates could severely damage the competitivity of U.S. companies.
Finally, the shield weight of the FED’s balance sheet helps hold down long-term U.S. borrowing costs, which is why the Fed bought bonds in the first place. If officials allow holdings to mature without continuing their current practice of reinvesting the principal, they could push yields higher by reducing demand in the bond market.
A significant increase in the hedging cost
For funds denominated in Euro, the short-term consequence is going to be an increase of the hedging cost. According to the different elements mentioned above and the fact that the ECB will be in hold mode at least until the end of this year, the gap between interest rates in U.S and the Euro area could be over 3% soon.
The impact on emerging economies
Emerging economies are particularly vulnerable to change in interest rates and the dollar’s valuation relative to local currencies. An increase in interest rates by the FED associated with a stronger dollar could hurt our universe in different ways.
Rise in corporate defaults
Many emerging market companies have benefited from low U.S. interest rates by borrowing in dollars and repaying debt with stronger local currencies. According to the Bank for International Settlements (BIS), there was about $1.1 trillion in dollar-denominated bonds issued by non-bank emerging market companies outstanding in Q3 2015 compared to just $509 billion at the end of 2008.
Higher U.S. interest rates could make these debts harder to service. It could lead to a wave of corporate defaults that could hurt our investees.
Lower Foreign Investment
With the low-interest rates environment in developed economies, a lot of investors have been attracted by higher rates in emerging economies. These economies became reliant on this steady increase in foreign investment to drive economic growth and witnessed significant expansion over the past several years.
Higher interest rates could draw more investors back to the U.S. and spark an outflow of capital from emerging markets. The most vulnerable to this kind of downturn are Turkey, Brazil, India, South Africa, Mexico and Indonesia.
Sovereign debt issues
Many emerging market governments took advantage of low U.S. interest rates to borrow in U.S. dollars. For example, South Africa borrowed heavily when the dollar was low and used the proceeds to help finance its growth and budgetary needs. These dynamics could lead to a lower credit rating and higher borrowing cost.
A higher borrowing cost could affect the potential of repaying debt or making harder to obtain new funding.
Commodity producers and the dollar
Many emerging market economies are reliant on commodities to drive their economic growth. For instance, Brazil and Russia depend heavily on crude oil and natural gas prices, while Chile and Peru rely extensively on copper and other hard commodities. If the dollar rises too much in value, it could affect the world growth and limit the demand for commodities. At the opposite, a moderate appreciation of the dollar could bring more revenues to these countries.