The interest rates set by the Federal Reserve are particularly one huge element which could determine the direction of the world markets ranging from equity to fixed income as well as commodities.
The effects are excruciating towards the financial markets rather than the world economy as a whole. It had already been proven that economic growth doesn’t get reflected fully by the markets or rather the real economy being delayed in contrast to market movements.
The chart above shows that although market sees a huge drop during recession years, there’s no correlation between how severe a market drops versus the recession that we are facing. 2009’s drop is definitely huge compared to the dotcom bubble burst. But the 1960s seems to see the worst market sell-off even without mass recession.
Ironically, the weak markets don’t equal a slowing economy, but a weak market could induce economy to enter a recession. Often times, a recession could be due to a complete shift towards a compression on the credit side of things by the central bank where this time around, the Fed leads the way. Again!
Moving along in a higher interest rate environment, we should see radical changes on corporate operations and investments which would partly affect the economy and slowing down in the end. A lower capital expenditure with the non-existence of cheap financing sees multiple projects being delayed and turn non-feasible for the time being.
Over the medium term, we are bound to see less economic activity arising from a credit crunch. Therefore, the initial market response had always been weak when the market expects a higher interest rate to be announced in one of those meetings.
Going back to Fed. In hoping to lower economic activities in the US due to the risk of overheating, the Federal Reserve is reducing the money supply in the system by increasing interest rates. It is really that simple for a central bank to reduce the amount of money supply in the system.
But in the modern age of finance, the narrowing gap for cross border investment and financing just pushed the reliance of the world to Fed higher. US dollars had turn into a gold standard where almost the whole world refers to. Fed’s monetary squeeze specifically tethered for the American economy isn’t going to work for other economies who are dependent on the US dollar investment. Some countries just aren’t ready for a credit crunch at this time.
A good example would be the case of our local companies who borrow in USD earlier thinking that it is much cheaper that ringgit borrowing. All of a sudden, these corporations see their cost of financing increasing rapidly due to Fed’s decision on rising rates.
A good start for theses firms would be to start paring down their debt reducing their balance sheet even though tapping into cash reserves becomes a must. This is for the exchange for less volatility ahead. But what about corporations with cash flow issues? The problem is just about to start but if not sorted properly, this weak matchstick fire could turn into a huge forest fire.
On the investment side of things after the 2009 crisis, a lot of money made it to emerging markets and not forgetting we are one of the few who is the most attractive at that time with high growth and high yield rates. But comparing to what it is now, dollar denominated investment especially on highly rated American treasury bonds is already rising. The earlier investments into things such as the Malaysian Government Securities (MGS) back in 2009 become less attractive compared to US government bonds when rates rise. Logically, I would want to liquidate some MGS to seek stability and safer haven for my money.
That keeps the tension rising for the sovereign funds holding our government debt on whether to shift and seek stability or stay and risk and unknown future. Already clear that the continuous devaluation just on currency alone had been painful to these funds. This explains the equity market rout over the second and third quarter this year. Since equity is very liquid compared sovereign debt, we see funds reducing their exposure and that results it a lower market today.
Once again, a financial crisis is brewing and the Fed might be blamed this time around. But truly, they shouldn’t be a part to be blame for causing issues like these. Corporates who seek high returns over-leveraging are the only culprit in this situation. Bad managers of debt for nations who took up cheap finance are the other.
However in Turkey’s case, it just so happen that most corporate debts mature roughly the same time. How could that even happen? You seriously couldn’t blame bad management or over-leveraging in this case. All we can say is luck isn’t on their side.
To sum it off, much like the Global Financial Crisis of 2008, continuous rising of interest rates causes debt to turn expensive creating a domino effect of defaults left and right. Perhaps one thing to be happy is that it isn’t that toxic compared to the housing bubble, emerging market sees the worst impact from this with the risk of devaluation if you are not ready to rise rates or capital flee for investments of government bonds.
With the market going crazy on trade war that is happening now, the debt problems that is arising could seems to be a minor distraction. But when the problems becomes huge, it turns into an issues which couldn’t be reversed anymore.