The recent rise in US bond yields, coupled with the likelihood of a further 25bps increase in the Federal Reserve’s targeted policy rates in December, has changed the conversations regarding the long-term outlook for US interest rates. The embedded narrative in recent years has been one in which the US economy would never reach a sufficiently sustainable level of economic growth or ‘escape velocity’ in order to warrant an end to the so-called ‘zero interest-rate’ paradigm.
The narrative has changed considerably in recent weeks with the focus increasingly turning towards questions such as how high US interest rates can ultimately go or when sustained higher rates will trigger a recession. Following on from this is the question of what this means for the US Dollar and therefore ultimately other major currencies around the world. These are the key questions we will attempt to answer or at least provide some perspective on, hopefully adding some insights to this debate in the process.
How high can interest rates in the US go?
Some of the recent shift higher in US bond yields has been the result of the election of Donald Trump and the expectation for substantial future fiscal stimulus under his administration. The underlying trend of improving growth, tighter labour markets and an uptick in wage growth had already been pressuring rates modestly higher in recent months. Although an increase in the supply, and therefore the amount of government debt outstanding, will place some upward pressure on real yields, the risk of a US default is zero. In fact it is essentially zero for any country with a sovereign Central Bank and its own currency.
Very simply, countries that can print their own currency can never default in the traditional sense and will ultimately default via higher inflation. As such, there is no technical limit to the size of the fiscal deficit a country can run nor the level of sovereign debt a country can accumulate as a % of GDP. For many countries therefore, it is the financial markets that will act as the ultimate enforcer of any real world limits to government spending and debt accumulation.
In this regard, Japan is probably the most relevant example. Public debt as a % of GDP now exceeds 200%, which makes US public debt levels of around 75% look quite tame. A large portion of debt is held by the Treasury in the various social security funds and therefore cancels out on a consolidation of all public sector accounts. In fact, our view is that the scope and capacity for the US to increase government expenditure and run much larger fiscal deficits is actually quite significant, in light of its existing public debt levels and the current level of longer-term interest rates which is still low by historical standards.
However, financial markets or fixed income markets for risk-free assets (government bonds) will only be concerned with one single factor over the long-term, namely inflation and the expectation of future inflation. Inflation is the only real risk faced by an investor buying government bonds in local currency. As such, it follows that future inflation expectations and NOT specifically expectations of future government spending or deficit and debt projections, will ultimately drive long-term nominal bond yields.
To be sure, increased fiscal deficit spending in an economy already operating at or near its potential rate of growth, will likely lead to higher inflation. In the case of the US, this indeed appears to be the possible outcome we can expect looking ahead to 2017. With US labour markets already at or near full employment, a substantial increase in fiscal deficit expenditures, will pose a real upside risk to inflation projections. It is therefore this dynamic, as opposed to the fear over the size of future deficits or debt levels, that have driven yields higher in recent weeks.
The same quantum of fiscal stimulus in an economy with substantial labour slack and growing well below potential, would have had a far less potent impact on market yields. As such, the key question for investors is what the likely evolution of future inflation trends in 2017 and beyond will be. As we have noted, there are clear upside risks to inflation looking out over the next few years. However, on the positive side, there are some ameliorating factors that may help contain headline inflation in the US to some extent, such as additional strength in the US Dollar on a trade-weighted basis.
Nevertheless, the offset from lower imported price inflation, will be substantially less over the next few years than was the case between 2014 and 2016, primarily due to the fact that global commodity prices are now no longer declining. Given recent investment and supply cutbacks, these will likely trend higher, reinforcing the growing inflationary winds in the global economy.
If inflation is still likely to trend higher in coming years it would suggest that nominal interest rates and yields will therefore as well. Naturally, the next question is how high can interest rates go before inducing a recession? Many often point to high levels of household indebtedness and suggest that the US economy simply cannot absorb a return to the interest rate levels that prevailed prior to the financial crisis in 2008.
However, we would argue why not? Although household debt measured as a % of GDP is high in a historic sense at roughly 80% of GDP, it is lower than what it was between 2005 and 2008.
More importantly perhaps, because interest rates in recent years have been much lower than at any time in the post-war era, actual debt-servicing burdens are at or near multi-decade lows.
The data and facts would suggest that the US economy is actually in a position to accommodate an interest rate level not only similar to that which prevailed prior to the financial crisis in 2008, but arguably even higher. On this basis, there is no reason to expect that short and long-term rates cannot eventually return to levels around 4% to 5%.
Is there anything that can then ultimately limit US interest rate levels?
However, having said this, there is one important difference between the present day landscape and that in existence prior to the financial crisis, namely the state of the global economy excluding the US. Prior to the financial crisis, much of Europe was still enjoying considerable growth momentum from the introduction of the single currency and the convergence to lower German interest rates. This ultimately resulted in the various credit and government debt bubbles at the periphery, which burst spectacularly between 2009 and 2012.
China was only midway through its ramp-up in large-scale infrastructure spend and was still enjoying the growth momentum from its cheap labour force and its admission to the World Trade Organization (WTO). None of these global tailwinds to growth exist today and in fact, as regards China, one could argue that the economy, given its evolving credit and property bubbles, now represents a meaningful future headwind to global growth.
In summary, what are we trying to say? We are suggesting that arguably the real upside limit to US interest rates will be neither US inflation nor the prospect of a US recession, but ultimately the outlook for global growth. A marked divergence in global growth dynamics in the context of large or widening interest rate differentials between the US and the Rest of World, would imply even greater upward pressure on the US Dollar. This could ultimately reduce inflation expectations and cap interest rates in the US.
The outlook for global growth, at least over the shorter-term, may be less dire than many now expect. Fiscal stimulus and acceleration in US consumption, coupled with an appreciating US Dollar, should in theory lead to a marked increase in imports into the US from export-dependent economies like China. In this manner, US fiscal stimulus may indirectly provide an important consumption and demand impulse for the global economy.
More positively, given the increase in US oil production, and consequent reduction in US imports, the US current account deficit as a % of GDP has narrowed considerably over the past decade. In 2006 and 2007, almost 50% of the deficit consisted of the country’s net energy imports, specifically oil.
As the US increasingly exports a portion of its large surplus of natural gas and oil production recovers following the recent price-induced slump, net energy imports may decrease to less than 1% of GDP. In theory, this would suggest that the potential size that the country’s non-energy trade deficit could now reach is much larger, perhaps as much as double, when compared to what it was pre – 2008.
As such, the implications for the potential size of a positive global demand impulse that could yet manifest in the years to come, is quite significant or potentially underappreciated. As noted, however, this positive dynamic could be countered at any stage if the US Dollar appreciates too rapidly or there is a disorderly devaluation of the Chinese Yuan. Importantly, given large offshore US Dollar-denominated borrowings (a legacy of the borrowing binge when USD rates we near zero), an appreciating US Dollar will lead to a tightening in global monetary conditions, indirectly choking off global growth outside of the US.
The outlook for the global economy will therefore critically hinge on the ability of any global demand impulse emanating from the US economy to sufficiently lift economic activity in its key trading partners while boosting exports and therefore the net trade surpluses of the US’s key trading partners. This would be necessary in order to counter-balance the potential capital flows attracted back to the US as a result of the prevailing higher interest rate differentials.
This delicate balancing act will likely become the new dominant narrative regarding the global economy and inform financial market expectations for the next few years. This is in contrast to the global stagnation and perpetual low-interest rate narrative that has prevailed over the preceding five years.