Rising rates seem like a valedictory return to “normality” — a marker of how successful the central banks’ heroic actions to counter the Great Recession were. What the celebration misses, though, is how swelling levels of debt will amplify the effect of any rate rises. According to the Institute of International Finance, global debt reached a record $237 trillion in 2017 — more than 327 percent of global GDP. Since 2007, when borrowing levels were a key factor in the financial crisis, debt has increased by $68 trillion, or more than 50 percent of global GDP.
In developed markets, the ratio of debt-to-GDP is around 380 percent. In emerging markets, the ratio is above 200 percent. While the rate of growth has slowed, this is only because of higher GDP growth — driven, in part, by increased borrowing. A decade of unprecedently low global rates and abundant liquidity appears to have encouraged a spree of public and private debt accumulation. If the current calm is an argument for raising interest rates, those higher rates may in turn be more destabilizing than many anticipate. This will be especially true if U.S. rate hikes flow through into other markets, as they did during the 2013 “taper tantrum.” For one thing, higher interest rates will exacerbate the risk of financial distress for highly indebted corporate and sovereign borrowers. This will particularly affect illiquid, riskier corporate and high-yield bonds, which have attracted significant attention as investors have sought out yield in the prevailing low-return environment.
Losses will flow into the banking sector. Since the start of 2018, the LIBOR–overnight index swap spread — a metric of bank credit risk — has increased from around 0.2 percent to 0.6 percent. The increase reflects, in part, a risk premium for the uncertain effects of U.S. monetary policy, increasing bank credit risk and rising demand for funds to guard against anticipated market stress. Second, higher rates will generate large mark-to-market losses on existing debt holdings. The loss from a 1 percent increase in U.S. government bond interest rates would exceed $2 trillion globally. Losses on corporate and other securities would add to the damage. Holders may be forced to raise capital or liquidate, compounding the pressure on rates. For banks, such losses could constrain their capacity to supply credit.
Third, higher interest rates will drive investors to switch from stocks and other risky assets to bonds. Lower stock prices may affect the collateral value securing financings. The debt-funded share buybacks and acquisitions that have propped up equity prices will slow down. Fourth, higher rates will divert cash to servicing debt. This will dampen economic activity, as companies reduce their investments in the real economy and households, burdened by record levels of borrowing in several countries, cut back on their purchases.
Finally, and perhaps most importantly, higher rates will restrict the ability of governments to deploy fiscal stimulus to extend and solidify the recovery. The U.S. is headed for trillion-dollar annual budget deficits from 2020, driven by tax cuts and higher public spending. Higher rates and rising deficits will sharply increase the amount needed for debt service as a percentage of expenditure. According to the Congressional Budget Office, net interest payments would rise to 3.1 percent of GDP in 2028, up from 1.6 percent in 2018. The problem will be compounded if growth slows because of higher rates, as well as other factors such as trade disputes and geopolitical stresses.
The idea that higher interest rates don’t matter because they will simply reallocate cash between borrowers and lenders is misleading. It assumes that the easy money of the past decade was spent productively and is generating the earnings required to service the borrowing. In fact, to a substantial degree, borrowings simply financed consumption and leveraged purchases of existing assets rather than new investment. At higher interest rates, many borrowers won’t be able to service the debt they’ve incurred. The Fed and others had better be prepared for a return to “normal” that’s anything but.