Higher interest rates test the system
Despite a brighter picture for growth, the global economy faces significant challenges. Data released last week revealed that Germany’s economy fell into recession in the first quarter of the year, the first major industrialised economy to do so in this phase of the economic cycle. UK inflation in April came in well above market expectations, adding to concerns that inflation may have become embedded in the system. In the US, the negotiations over the raising of the ceiling for federal borrowing have raised the spectre of the US government running out of money.
More broadly high interest rates are testing the financial system and balance sheets around the world. Balance sheets and financial structures created in a period of near-zero interest rates now face rates closer to 5.0% in the US and UK.
Rising interest rates have raised stress in pockets of the financial markets, such as the US regional banking system, precipitating the collapse of SVB, Signature Bank and First Republic Bank. But, so far, they have not exposed any systemic weaknesses in the financial system as happened in the global financial crisis and in most previous rate-hiking cycles.
The financial system looks far more resilient today than 15 years ago, on the eve of the financial crisis. Regulation has curbed risk taking at big banks and improved their capital holdings and ability to withstand financial shocks. Low interest rates have encouraged households to lock-in mortgage rates for longer periods than before, slowing the pass through of rate rises to consumers. In the UK the vast majority of mortgages are fixed rate now and most mortgagors have yet to be exposed to higher rates. During the financial crisis, the majority of British mortgages were on variable rates.
Large corporates too have opted for longer-term fixed-rate debt. Analysis by S&P Global shows that three-quarters of non-financial corporate debt in the US and Europe is on fixed rates today. This gives businesses time to adjust to rising rates.
Where vulnerabilities have emerged, the authorities have moved quickly and forcefully to prevent contagion. In the US the authorities protected depositors to prevent the failure of three banks developing into a wider bank run. Last September, the Bank of England responded to a sell-off in UK government bonds triggered by the mini-budget with a major programme of gilt purchases that calmed markets.
But this remains an uncertain environment with the IMF observing in April that “Financial stability risks have increased rapidly… Market sentiment remains fragile…as investors reassess the fundamental health of the financial system”.
The most immediate risk – and one that, at the time of writing, was receding – is that of a US sovereign default if Republicans and Democrats were to fail to reach an agreement on raising the debt ceiling. Without such an agreement the US government is likely to run out of money to cover its obligations by early June. If that came to pass, the Federal Reserve and the Treasury have a plan to avoid an immediate default, buying policymakers some time for further negotiations. If those talks failed and the US defaults, treasury yields will rise, tightening credit conditions across the globe.
Elsewhere in the financial system several US regional banks are continuing to see deposit outflows. Since the collapse of Silicon Valley Bank there has been a marked decline in the number of accounts with balances above the $250,000 federal deposit insurance limit held at midsized lenders – depositors have been shifting cash to larger banks to avoid potential risks in small institutions. Earlier this month, shares in PacWest, a Californian bank, sold off sharply after it revealed a 9% reduction in deposits over just one week. Many of these banks also have significant unrealised losses on their securities portfolios. Continued large outflows of deposits could prove challenging for them. The Fed, however, believes that the more regulated large banks have ample liquidity to withstand short-term deposit outflows.
Cash buffers built during the pandemic and fixed-rate debt have helped the non-financial corporate sector weather this rate rise cycle so far. But weak growth, sticky inflation and higher interest rates are putting some corporates under strain. The risks are greatest among smaller, more indebted businesses. According to Goldman Sachs, the average interest rate on variable-rate loans to such firms in the US has almost doubled over the last 12 months. Analysts at S&P Global see bankruptcies of private equity-owned businesses, often small and laden with debt, as set to double from last year in the US. This will also add to the concerns of pension funds and institutional investors who have heavily funded private equity over the last decade.
Policymakers are also focussed on the commercial real estate market, which has been knocked by rising interest rates and a step change in demand for office space following the pandemic. The effects are evident in large price corrections for real estate investment trusts across the developed world. There are signs of overcapacity in warehousing but the greatest concerns are in the office space sector, especially in the US, where office vacancy rates are close to a 30-year high.
As markets reprice commercial property, some landlords might find themselves unable or unwilling to hold onto office space in a higher rate environment. Some worry that US banks, that have lent to property developers, might end up with these properties on their balance sheets, valued at a discount. Given that commercial-property loans are usually capped at around 75% of the property's market value, the banking sector could absorb some decline in the value of office space. Nonetheless, the exposure is uneven and some banks could face material risks.
In emerging markets, the greatest risks lie in sovereign debt. A strong dollar and rising interest rates have made servicing dollar-denominated debt a growing challenge for some smaller emerging market economies. Alongside Russia and Belarus, last year saw sovereign defaults by Ghana, Malawi and Sri Lanka and a debt crisis in Pakistan. According to the IMF, there are 12 emerging market sovereigns in debt distress, all of whom are smaller economies. Major emerging market economies such as China and India or oil-exporting middle eastern economies do not face debt sustainability concerns or the risk of recession.
The final source of risk on our list is the household sector. High inflation and rising interest rates have put consumers under growing pressure. A wave of defaults by individuals, whether on mortgages or consumer credit, would hit consumer spending, the main component of GDP growth. But the story in the household sector has been one of surprising resilience so far. In the face of multi-decade high inflation and a sharp rise in interest rates, the household sector has largely continued to service its debts and consumption has held up relatively well. This could change if inflation persists, forcing central banks to raise rates aggressively to trigger a downturn. Significant rises in unemployment and a readjustment in asset prices would mean greater pain for households.
Most major interest rate raising cycles result in problems emerging in the financial system. More colourfully, as the Wall Street saying has it, “The Fed tightens until something breaks”. Thankfully the breakages so far have been limited. Regulators and policymakers will need to work hard to keep it that way.
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