When nominal interest rates, such as those on government bonds, exceed the nominal growth rate of a country’s economy, it triggers a cascade of economic consequences. Here are some of the key repercussions:
- Government Debt Burden: As the cost of financing government debt outpaces economic growth, the government’s debt burden continues to rise.
- Corporate Challenges: High interest rates put pressure on firms, making it difficult for them to service their debt.
- Household Struggles: Higher interest costs relative to wage growth make it challenging for households to service their debts, potentially undermining consumer spending.
- Asset Value Impact: Increasing the risk-free interest rate reduces the nominal value of assets, affecting financial markets. Real assets financed with short-duration or floating-rate loans are particularly vulnerable.
- Banking Sector Woes: Banks face higher deposit costs, and those with asset-liability mismatches may find their borrowing costs surpassing earnings on their investment portfolios.
- Rising Risk Aversion: Investors become more risk-averse as risk premiums rise, which tightens the cost of funds in financial markets.
These consequences can ultimately lead to economic slowdowns and pose a significant risk to the stability of the financial system.
For decades, the US dollar has held a unique position as the world’s primary reserve currency. Central banks worldwide have traditionally recycled their current account surpluses into US assets, creating a symbiotic relationship. However, recent events, notably the Ukraine conflict, have disrupted this cycle. As a result, US deficits could now trigger dollar depreciation, unless the United States entices capital inflows through higher interest rates.Historically, the United States wielded considerable influence over the global capital flow cycle, with other central banks accumulating US Treasury Bonds as a matter of course. Therefore, changes in US monetary policy reverberated across the globe, impacting central banks worldwide.
Also, in the past, discretionary capital flowed predominantly from the United States to the rest of the world. However, this dynamic has shifted. The United States, facing current account deficits, now relies on capital inflows to maintain stability, marking a reversal in the discretionary flow of funds. Today, capital is flowing from the rest of the world into the US. This significant transformation is one reason why Asian countries, for instance, are not as adversely affected by the rising interest rates in the US.
But, this presents a quandary for the Federal Reserve. Should they prioritise domestic economic stability or safeguard the value of the dollar? The answer likely leans toward the domestic economy, as a financial implosion at home could have catastrophic consequences. A slower economy with a reduced current account deficit may help the Fed avoid a financial disaster and defend the dollar’s value.
However, the challenge lies in the hands of the Biden administration, which faces elections next year. To support the Fed’s efforts to slow economic growth, the government may need to reduce fiscal spending and increase taxes. Without such cooperation, the Fed’s task becomes increasingly daunting, and the spectre of a financial market implosion looms.
In these uncertain times, finding the right balance between domestic economic stability and global financial order is a formidable challenge. The fate of the US economy and its role in the world hinges on the choices made by policymakers in the coming months.
From an investment point of view, the first space to hide is US Treasury Bonds, although the outlook on the US economy will deteriorate in either situation which will in turn lead to deterioration in the outlook on the dollar. The second place is gold which will benefit in either of the situations. If the Fed tries to defend the dollar, the probability of financial implosion in the US is high, if the Fed tries to support the economy in an expansionary fiscal environment, the chances of financial explosion go up.
(The author is CIO-Fixed Income at ICICI Prudential AMC)