False dawn in America

Markets are expecting big things from Donald J. Trump’s presidency, at least as judged by long-term U.S. interest rates. After Trump’s election in November, 10-year and 30-year rates peaked at above 2.6 percent and 3 percent, respectively, increases of about 75 basis points.

Emerging-market rates have risen by similar amounts. (European and Japanese increases have been more modest, primarily due to continued aggressive purchases by the European Central Bank and Bank of Japan.) While rates have retreated somewhat, they remain well-above lows of 2016.

This should be good news. Higher rates suggest that investors see stronger growth and healthy inflation – due to a tight labor market, wage pressures and higher commodity, especially oil, prices – ahead. The problem is, those same rising rates are likely to derail any recovery before it occurs.

Most obviously, higher rates pose a problem for bondholders: Globally, a 1 percent rise in rates would result in mark-to-market losses on existing holdings of bonds of $2 trillion to $3 trillion. Such an increase would also punish borrowers; given high U.S. leverage – around 250 percent of GDP – a 1 percent rise in interest rates would require a 2.5 percent rise in incomes to meet existing debt commitments.

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Hopes for a large-scale spending binge on infrastructure could be dashed as well. Over time, a 1 percent rise in long-term rates would increase the interest bill on $20 trillion of U.S. government debt by $200 billion. That’s nearly half the current projected 2017 federal budget deficit of $441 billion. Finding the money for roads and bridges could soon get more expensive and harder.

So could the challenge of reviving U.S. manufacturing – a promise that was key to Trump’s victory. Since the election, the U.S. dollar has risen by around 6 percent against the euro and 12 percent against the yen. A stronger dollar damages the competitiveness of U.S. exporters and raises the costs of bringing manufacturing back onshore. A 10 percent rise in the dollar increases the U.S. trade deficit by around 1 percent and decreases growth by between 0.2 percent and 0.5 percent.

Perhaps most dangerously, higher rates could set off financial market instability. Global bank shares have risen by more than 20 percent since Trump’s victory; U.S. bank stocks have gained between 40 percent and 70 percent. Higher rates have added to the optimism, with analysts arguing that banks will soon be able to increase lending rates more than deposit rates, improving margins.

This ignores competition between banks, however, not to mention weak loan demand. And higher U.S. rates will pressure emerging-market borrowers. Even where emerging-market borrowers have borrowed in local currency, foreign investors hold a significant proportion of the debt. A stronger dollar may force investors to sell some of these holdings to contain losses, forcing up emerging-market borrowing costs and resulting in further devaluations.

Despite what some investors would like to believe, Trump hasn’t ushered in a new “morning in America.” In 1981, when Ronald Reagan took office, the economy was just coming out of recession, not growing on the back of extraordinary monetary accommodation. Interest rates were at record highs, not record lows. Debt levels were one-quarter of current levels. Assets were undervalued instead trading at record values inflated by central bank policies. Today’s optimism, given current conditions, looks much more likely to be a false dawn. •

Satyajit Das is an author and former banker. Distributed by Bloomberg View.

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