25 September 2015

Global Implications of a Fed Rate Hike

Much has been written about the recent decision by the Federal Reserve to hold off on raising interest rates. In this piece we wanted to highlight what a difficult spot the Fed and other Central Banks are in as the global economy soon heads into its next crisis.

About two weeks ago we wrote an article about how interconnected the global economy is. In fact the global economy is so interdependent that it is becoming a problem for the Federal Reserve.

The global implications of a Fed rate hike are significant. Especially when you consider that the European Central Bank, the Bank of Japan and the Peoples Bank of China are all engaged in stimulus programs right now. As a result, a rate hike by the Fed could send the Dollar soaring.

Earlier this year Bloomberg's Dollar Spot Index that tracks the US Dollar against 10 major peers, including the Euro and Yen increased 20% since the middle of 2014. So the Fed is now backed into a corner unable to raise rates due to the fear of a rising Dollar.

Rising US interest rates will create a massive wave a bankruptcies for Dollar denominated debt holders outside the US. 

The Fed’s 9 Trillion Dollar Problem

The biggest problem could lie in countries outside the US that have borrowed in US Dollars. According to a story in Bloomberg, sovereign and corporate borrowers outside the US owe a record $9 trillion in Dollar debt. Much of this will need to be re-payed in the coming years. (Source: Bloomberg 2015 April 12th)

One needs only to look at the emerging markets to understand how much of a problem US Dollar debt will become for the world economy. Low interest rates in the US have led companies around the world to borrow money in US Dollars.

The Wall Street Journal reported recently that:

“The amount of dollar-denominated loans to borrowers in emerging markets, excluding banks, has nearly doubled since 2009 to more than $3 trillion”. (Source: wsj.com 2015 September 13th)

When the Dollar rises in value it makes debt more expensive to pay back in a local currency. The other issue is that many of these emerging market countries rely on commodity exports to fuel economic growth. 

The collapse in commodity prices likely means the global economy is slowing down. As a result, slower growth along with an increase in debt payments is starting to have a big impact on emerging market economies.

Brazil’s Perfect Storm

To understand the the magnitude of the problem, one needs to look no further than Brazil.  According to an article in Bloomberg, the nations credit rating was recent cut to junk, which means its bonds could be at risk of a default.

Brazilian companies have accumulated $270 billion in debt. The article highlights that since 2007 banks and non-financial companies have more than doubled their dollar-denominated debt. (Source: Bloomberg 2015 September 13th)

However, the bigger problem is that the Brazilian currency, the Real, is down 30% this year making it the world's worst performing currency. So banks and corporations who have borrowed in US Dollars have seen their debt increase by 30% because of the collapsing currency.

The Feds massive quantitative easing program that has taken rates down to near zero has fueled a Dollar debt binge that somehow has to unwind itself. Companies and institutions outside the US that have borrowed in the US currency are now seeing debt service payments soar.

Emerging Markets are at Risk 

The problem is not just isolated to Brazil. In a recent article in ZeroHedge top performing hedge fund manager, John Burbank, from Passport Capital said years of quantitative easing has caused a misallocation of capital around the world: 

"The wrong people got the capital — emerging markets countries and corporates and a lot of cyclical companies like mining and energy, particularly shale companies — and this is now a major problem for the credit markets”.

We are now beginning to see the consequences of this and one of the places it may manifest first is in the Emerging Markets.

In the article he went on to say:

"I think we are on the precipice of a liquidation in emerging markets, and this feels the way that the fourth quarter of 1997 felt”. (Source: ZeroHedge 2015 September 21st)

Of course 1997 was a year gripped by the Asian Economic Crisis followed by the Russian Economic Crisis in 1998, which caused the collapse of legendary hedge fund Long Term Capital Management.

Trillions of Dollars of bad investments that have been created over the past seven years are going to have to be liquidated. This is why defaults will soon begin to skyrocket.

Interest Rates at Historic Lows

The other big problem that has been written about recently is that many of the world Central Banks now lack the tools to deal with the next crisis. According to an article in Business Insider, interest rates are at there lowest levels in 5,000 years of civilization! (Source: Business Insider 2015 September 18th)


Business Insider Chart Interest Rates

Source: Business Insider: 5,000 year history of interest rates

In addition to rates being at 5,000 year lows, in the US, short term interest rates have never been this low for this long. These two data points are bad news for the Federal Reserve and other Central Banks.

Although the Fed will likely attempt to continue to keep rates below normal levels for the foreseeable future, the market will soon force the issue and demand higher rates. The above chart says it best. With rates at 5,000 year lows, they must eventually head higher. Fed Chair Yellen said in a speach yesterday the FED may still raise rates in 2015. So it's a bit back and fortth with no clear direction.

Which means we are already seeing the confidence in the Federal Reserve erode. As this continues into next year, rates on the long end of the curve will start to move higher, which will become a major problem for corporations and governments that have too much debt.   

Even the IMF said earlier this year in its Global Financial Stability Report that: 

A “sudden rise” of 1 percentage point in the 10-year Treasury yield is “quite conceivable” if a Fed interest-rate increase comes sooner than investors anticipate, the IMF said. “Shifts of this magnitude can generate negative shocks globally, especially in emerging-market economies".

(Source: Bloomberg 2015 April 15th)

Gold and Silver

In this article we outlined one of the trigger points that could result in the start of the next major global economic crisis. However, as we have said before, predicting exactly how major evens will unfold in the future is challenging. Often times the catalyst comes from some region or event that no one expects.

The risks to the global financial system are increasing. With a deeply interconnected global economy the next crisis could come from any region of the world and quickly spread.

This is one of the reasons why we continue to encourage Gold and Silver investors to keep focused on the big picture and long term. Many experts are predicting some type of crash to hit the global markets in the coming months.

Should that happen Gold and Silver may experience a temporary downward spike. A debt liquidation or stock market crash is deflationary. So this could impact Gold and Silver over the short term.

However, collapsing bond prices, plunging currencies and a loss in confidence in the financial system will eventually lead to much higher Gold and Silver prices. This is the major trend to be positioned for.

Another scenario the investors needs to know about is negative interest rates and gold. We will share our views on this next week here in the Gold University.

Author: celticgold.eu

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