Rising Interest Rates and the Federal Reserve
The US economy is cranking out robust figures 10 years after the start of the global financial crisis: strong growth, historically low unemployment, a soaring stock market.
But with the good news come rising interest rates as the Federal Reserve — which on Wednesday is expected to raise the key lending rate for the third time this year — tries to keep the economy from overheating.
And after a decade of very low rates that enticed many to load up on debt, rising borrowing costs can expose hidden risks lurking in the US and world economies.
So where are they?
– Mortgages? Not this time –
Unlike the runup to 2008, this time mortgages are not expected to be the root of the next crisis.
While US home loans continue to form the large bulk (68 percent) of household debt, and totaled $9 trillion through June 30, according to the New York Federal Reserve Bank, they are much healthier now.
The share of loans going to homebuyers with low credit scores is very small, and the delinquency rate on payments has declined to just over one percent, close to 20-year lows, according to quarterly data.
Meanwhile, the share of adjustable-rate mortgages, or ARMs, remains a very low, 5 percent to 6 percent compared to 35 percent in 2005.
It was these ARMs which caused numerous defaults during the crisis when monthly payments skyrocketed and homeowners who counted on refinancing could no longer afford their homes.
Instead, homeowners have “locked in, many at extraordinarily low rates,” Mortgage Bankers Association Chief Economist Michael Fratatoni told AFP.
The average rate for a 30-year mortgage was 4.9 percent in the latest week and is only expected to rise to 5.3 percent by next year, he said.
– Consumer debt more worrying –
Of more concern than mortgages are auto and student loans, in the first case because of the rising number of borrowers with low credit scores and in the second because of the growing total.
However, economists say that while the situation is increasingly worrying for individual households, these debt categories are unlikely to create systemic risks for the financial sector.
Outstanding student loan debt stood at $1.41 trillion as of June 30 and about 11 percent was delinquent or in default.
The New York Fed previously has flagged the auto loan sector — with a total outstanding of $1.24 trillion — as finance companies extend an increasing amount of loans to subprime borrowers, or those with low credit scores, causing the median credit score to decline steadily and delinquencies to rise.
– Corporate bonds could hit a wall –
After years of very low borrowing rates, companies have taken advantage to issue debt and found willing buyers for the bonds that were among the few options offering a return on investment.
That search for yield has led to investors snapping up an increasing share of lower-rated debt, known as speculative grade.
William Rhodes, former senior vice chairman of Citigroup, warns that the financial sector “failed to learn the lessons of the last global crisis.”
“In their reach for yield they have continued to make short-term gains their paramount objective and now they are set to be burned,” he said in a recent column.
The concern is not just limited to the US bond market: there are similar worries in China, Latin America, and elsewhere. And that risk is greater since many of those companies have contracted US dollar-denominated debt.
“The recent debt binge has investors increasingly concerned about the ramifications if the credit cycle turns,” S & P Global Ratings said in a recent report.
S & P says the amount of US corporate debt coming due in the next three years is manageable but from 2022 about half the maturing debt will be speculative grade, more vulnerable to a change in market sentiment and more difficult to refinance.
The greatest risk lies in the retail sector and the oil and gas industry, according to the report.
Faced with competition from e-commerce and dying malls, the retail sector saw defaults peak in 2017 and there are $50 billion in speculative grade bonds coming due in the next three years.
Meanwhile, the oil and gas sector issued a historic amount of debt through 2015 and the “industry faces massive refinancing needs in the next several years that could pose a significant risk,” especially if oil prices fall.
– Sovereign & currency risk –
Like companies, emerging market governments also have loaded up on debt but the International Monetary Fund says that in many cases they have improved their economic fundamentals in the wake of the crisis, making them able to withstand some instability.
However, as the Fed raises interest rates, dollar borrowing costs will increase for these countries, at the same time as the US dollar will gain in value as investors take their money out of emerging markets and into dollars.
The IMF warned in a report in April that “a considerable number of low-income countries and other small non-investment-grade issuers have experienced a sharp deterioration in debt sustainability.”
And if something happens to spook investors, making them more risk averse — like a trade war — that could accelerate capital outflows, “and put growth at risk in some emerging markets.”