Economic e-news - August 2018

09 August 2018

By Craig Turnbull
Chief Investment Officer


Global debt and the threat of higher interest rates

In the wake of the global financial crisis, central banks around the world, including the Reserve Bank in Australia, cut official interest rates to historic lows to restore confidence and stimulate their economies.

Governments, business and households responded by borrowing at record levels and the Institute of International Finance (IIF) estimates that total global debt has soared to US$247 trillion, equal to 318% of global GDP.

And with some central banks, like the US Federal Reserve, now in the process of ‘normalising’ or raising official interest rates, many market analysts are concerned about what impact higher interest rates will have on the global economy.

 

Source: US Federal Reserve

Why is the US Federal Reserve raising official interest rates?

The US economy has been expanding quite rapidly over the last two years with the annual GDP growth rate up from 1.3% in 2016 to 2.8% in the June quarter, and many analysts are tipping the growth rate to climb higher over the next 12 months.

Low interest rates and the tax cuts have been driving up US business investment and household spending, and this has been slowly fuelling the rise in the core US inflation rate, up to 2.3% in June.

The US Federal Reserve has raised rates seven times since 2015, and is expected to move again in the coming months, with three more rate rises planned for 2019.

The aim is to keep a lid on inflation by reducing the total amount of money circulating in the US economy because higher interest rates mean less people borrowing money and more people saving their money.

But the decisions of the Federal Reserve not only affect the US economy, these rate rises send ripples across the globe.

What impact does the US Federal Reserve have on the international economy?

When the US Federal Reserve raises official interest rates, the cost of borrowing increases for any governments, businesses or individuals who have loans denominated in US dollars.

This is an issue for all countries but in particular, emerging market economies, for example, Turkey, South Africa, Brazil and Argentina. These countries borrowed in US dollars when US interest rates were historically low and the IIF estimates that around US $1 trillion of these debts will mature in 2018 and 2019.

Rolling over these debts will mean these borrowers accepting higher interest rates and as a result spending a larger proportion of their income servicing these debts.

Interest rates can also influence the value of the exchange rate with other countries.

If one country has higher interest rates relative to other countries, generally speaking, it tends to attract more foreign investment and this increases the demand for the local currency as well as its value or exchange rate against other currencies.

So if the value of the US dollar rises, this places an extra burden on countries with US dollar debts as their repayments must also be paid in US dollars. There’s a fear that if some emerging economies start to struggle, it may undermine global confidence.

What does it mean for Australia?

Rising interest rates and a stronger US dollar will mean increased borrowing costs for governments, business and some individuals in Australia, as well as pushing up prices on any imported goods that are paid for in US dollars.

These cost pressures are likely to flow through to higher inflation, putting more pressure on household budgets already restricted by persistent low wage growth in recent years.

But there may be some benefits for Australian investors.

A lower Australian dollar means that any investments denominated in US dollars, such as US shares or fixed investments, are likely to rise in value, boosting returns for local investors with an exposure to these types of assets.

 

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Markets at a glance

for the month ending 31 July 2018

upArrowAustralian sharesup by 1.39%
upArrow Australian Government Bonds yield2 up to 2.650%
upArrow Australian dollar up to US$0.7431
noArrow Cash ratesteady at 1.50%
upArrow International shares4 up by 3.07%

 

1 ASX 200 Accumulation Index
2 Yield on 10 year Australian Government Bonds
3 RBA cash rate
4 MSCI – World ex Australia (USD)

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