Higher interest rates test the system

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.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 1.7% at 7,627. The index dropped as investors revised up their expectations for further rate rises from the Bank of England. This followed the news that UK consumer price inflation in April had come in ahead of expectations for the third month in a row.

Economics

• Early estimates of activity in May compiled from surveys of purchasing managers suggest continued strong growth in activity in the US, euro area and the UK as an expanding service sector more than offset a decline in manufacturing activity
• Senior Democratic and Republican leaders in the US said they were confident that they have the votes to pass a deal this week to avoid a potential US debt default
• The US Personal Consumption Expenditures Price Index (the Fed’s preferred inflation measure), US consumer spending and durable goods orders all came in ahead of expectations in April, strengthening the case for further tightening by the US Fed to control inflation
• UK inflation slowed less than expected, with consumer prices rising 8.7% in the 12 months to April 2023, down from 10.1% in March, in part due to rising prices for second-hand cars and cigarettes offsetting a fall in energy costs
• UK core inflation rose to 6.8% in the 12 months to April, up from 6.2%, suggesting a continued persistence in inflation
• Expectations for UK interest rates rose on the news, with markets expecting interest rates to peak at 5.5% later in the year, up from 4.9% at the start of last week
• UK government borrowing costs and mortgage rates, which closely follow interest rate expectations, also rose on the news
• UK health secretary Steve Barclay said that government plans to impose price caps on staple food items would have no “element of compulsion”. Retailers have been critical of the plans
• UK energy regulator Ofgem announced that average UK household energy bills would fall to £2,074 a year from July
• UK retail sales grew by a greater than expected 0.5% from March to April following a drop of 1% in March, partly due to bad weather
• The UK is estimated to have record net immigration of 606,000 people in 2022, roughly double pre-pandemic levels. The ONS cautioned that estimates are uncertain
• German statisticians revised their initial estimate for GDP growth in the first quarter of 2023 from 0.0% to -0.3%, meaning that Germany, having also recorded a contraction of 0.5% in the last quarter of 2022, entered a technical recession

Business

• A report by the Tony Blair Institute for Global Change called for UK pension funds to be amalgamated into ‘superfunds’ to boost investment in UK startups, businesses and infrastructure
• The market valuation of the 14 largest private equity investment trusts is 36% below their reported net asset value, suggesting investors may be sceptical of the valuations reported by fund managers, the FT reports
• Travellers to the UK faced long delays last week as a technical fault led to electronic passport gates not working
• Netflix launched a crackdown on password sharing in over 100 countries, aiming to increase revenue from the estimated 100m people sharing accounts
• Norway’s $1.4tn sovereign wealth fund said that it would support shareholder motions to force oil majors ExxonMobil and Chevron to introduce emissions targets
• UK chemicals businesses warned that a failure by the UK government to introduce a new regulatory regime following Brexit risked causing them serious harm
• The German government is facing a backlash over its plans to ban new gas boilers in homes from next year
• US chip maker Nvidia issued a revenue forecast well above market expectations. Nvidia looks set to benefit from a rise in demand from AI, for which its chips appear well positioned

Global and political developments

• Spanish prime minister Pedro Sanchéz announced a snap general election after his Socialist party suffered heavy losses in local elections
• Turkish president Recep Tayyip Erdoğan narrowly won a run-off election against challenger Kemal Kılıçdaroğlu, by 52% to 48%
• Russia launched its largest drone attack against Ukraine on Sunday. Ukrainian officials said that 58 out of 59 drones were downed by air defences
• The EU is considering sending the profits from the almost €200bn in frozen Russian assets to Ukraine
• Russia claimed that it had reclaimed Russian territory that was briefly taken by pro-Ukraine militias
• Canada and Saudi Arabia restored diplomatic relations five years after Canada suspended them over Saudi Arabia’s human rights record
• Former UK prime minister Boris Johnson was referred to police over further potential breaches of lockdown rules
• Governor of Florida Ron DeSantis announced that he would run against former president Donald Trump to seek the Republican nomination in the 2024 presidential elections

And finally… the BBC reported last week that an Indian official was suspended after he ordered that two million litres of water be drained from a reservoir so that he could retrieve his dropped phone – dam shame