America’s economy is improving and the Federal Reserve Bank is looking to increase interest rates. We will find ourselves having to compete for less and less available financing that we have become addicted to, as systematically important central banks such as the Federal Reserve are gearing to tighten money supply and consequently raise interest rates. But how did we get here?
In 2001, the US economy suffered two body blows. Not many remember this but towards the end of Bill Clinton’s administration, the US economy saw what we now call the dot com bubble burst. This was followed quickly by the nine-eleven which was a terrorist attack on America by Al Qaeda in the year 2001.
Thanks to this, the US Fed decided to increase money supply to lower interest rates and support both consumption and investment. This is what was behind the boom in asset prices and commodity prices that came to a head around 2007. If one remembers correctly, oil prices hit $120/bbl in international markets. Gold went to $1,800/ounce and stock indices were at record highs.
The Fed was forced to tighten to avoid an inflationary crash. The Federal Reserve Monetary Policy Committee moved the Fed Funds from 1% in mid-2004 to 5.25% before 2006 was over. This is more than doubling the Fed funds rate every other year, a shock the US economy struggled to cope with and caused the asset bubbles to burst.
This collapse in asset prices exposed the financial sector which was thinly capitalized and saw quite a bit of equity wiped out. This forced Hank Paulson and Timothy Geitner to secure funding from tax payers to underwrite the banking system, AIG and other systematically important financial services entities.
In a bid to kick-start the economy, the Fed funds rate was pushed down to 2% in 2008 and 0.25% by 2009. The Federal Reserve saw its balance sheet more than double in less than two months moving from USD 900Bn on 1st September to USD 2.1Tn by 10th November 2008.
As we observed in the earlier business cycle which lasted from 2001 to 2007, the Fed drove the US economy and global commodity prices. In the subsequent business cycle that started around 2008, we are seeing the same policy response experienced in 2001. The second cycle is somewhat different though.
In the second cycle, the banks have just gone through a harrowing period and are reluctant to lend and would prefer to engage in safer investments such as government bonds. That is why central banks and specifically the Fed brought interest rates so low forcing banks to start lending to the general public again.
Naturally, banks started reaching for yield. This means that banks started lending off-shore where they found higher yields with, possibly, similar risks. As earlier intimated, governments are considered safe borrowers because their ability to pay doesn’t depend on their ability to sellbuton their ability to tax which is usually very high. In case of near default, banks can count on entities like the IMF and World Bank to manage the situation as opposed to private borrowers who may not have a cure for any risks that may occur in the future.
That is how many emerging markets and frontier markets started borrowing to finance development of infrastructure based on the low prevailing rates. Many of these governments became hooked on this debt as between 2008 and 2015 the US Fed rate started at 0.50% but was mostly at 0.75% which many governments learnt to live on.
As we speak today, the Fed funds rate is at 1.50% which is double what it was two years ago. That means interest costs for some has doubled and may continue to rise going forward.
At this time, if the American economy continues to rally in spite of the trade wars they are embroiled in against China and other countries, we can expect interest rates to rally. This will likely mean that countries that have become addicted to dollar borrowing will face serious refinance risk and will be required to tighten monetary policy to defend their currency in order to manage the cost of their dollar debts.
This will require austerity and more supply side as opposed to demand side driven growth. It is why we say in trepidation during such times that we need to beware of the Federal Reserve. Our economies depend on it.
Johnson Nderi is Manager, Corporate Finance and Advisory at ABC Capital Ltd. He has a wealth of capital markets experience having previously been Head of Research and Head of Corporate Finance at Suntra Investment Bank.