Kenneth Rogoff, an American economist and chess grandmaster who is currently a professor of public policy and economics at Harvard University, once said, “If it goes wrong for the US, it goes wrong for everyone.” Considering that the world is a global village of heavily independent economies with the US being the largest by GDP of close to $20 trillion, Rogoff was probably right.
On that basis, using the US economy as a barometer to scrutinise probable global prime market disruption candidates for 2021 appears to be a reasonable proxy. Notably, Janet Yellen, the US treasury secretary, recently called on the rest of the G7 member states to follow suit on her government’s plans to borrow and spend. Given the influence that the US has on the world economy, any experiment by the US is likely to have a global impact.
This article discusses two key global market disruption candidates for 2021, using the US economy as a proxy. The two prime candidates are a rapid rise in US bond yields and a strong US dollar.
Rapid rise in the US bond yields
To spur borrowing and bring economies out of the doldrums of the pandemic-induced recession, last year the Fed and most other central banks across the globe cut interest rates to near-zero levels. Bond yields across all maturities hit record lows. However, in recent months, developments on COVID-19 vaccines and expectations of more fiscal stimulus under a blue-led Congress meant that the path of least resistance for US yields has been to go higher.
Currently, the yield on the closely watched bond yield, the benchmark 10-year Treasury note which is used as a sign of investor sentiment about the economy, is at 1.35%, after hitting a record low of 0.32% in 2020. By comparison, the same benchmark was 1.56% a year ago and has a long-term average of 4.38%. Higher energy prices, rising stock markets, the possibility of another fiscal relief package, and record-high Treasury auctions all represent the myriad of factors pushing rates higher. Though bond yields remain historically low, a rapid increase can ripple through to other assets, affecting everything from equities to the housing market.
The risk is that the Fed, which sees rapid rises in yields as a threat to the economic recovery, would likely put a cap to such a rally in yields. This action by the Fed, and other central banks by extension, will likely result in a ‘taper tantrum’, when yields rise sharply as the Fed begins winding down its monetary support earlier than expected. Worries over an earlier-than-expected stimulus unwind in 2013 hit investor appetite for corporate bonds and caused a sharp sell-off in equities.
While the stock market rallied as bond yields hit historic lows last year, equities can suffer from higher yields, as bonds and other money market instruments, which are considered safer, begin to offer reasonable compensation to yield-seeking investors. On a household level, the interest rates charged on the fixed-rate mortgages always mirror the moves in the bond (treasury) yields. The higher mortgage rates will cripple the housing market which is closely linked to consumer spending. Even though currently, mortgage rates are lower which is causing a lot of people to borrow, higher mortgage rates will make housing less affordable and depress that market. It means one has to buy a smaller, less expensive home. That can slow gross domestic product growth. The average rate on a 30-year mortgage, based on data from the Mortgage Bankers’ Association, has already begun edging higher.
A strong US dollar
A recent report from the International Monetary Fund showed that over 60% of the world’s currency reserves are held in US dollars, more than double the combined foreign holdings of euros, yen and that of the renminbi,making the world’s most dominant currency or rather the safe-haven currency.
Currency movements have always been complicated both in their causes and consequences. The currency market is one of the only liquid asset classes which have currently experienced limited central bank manipulation as government interventions to prop up exchange rates have been very rare. The absence of central bank and government intervention in the currency market has not dampened volatility. There is a growing possibility of a rally in the US dollar as US bond yields continue to rise while economic growth differentials relative to other major countries is likely to widen after the pandemic.
The US dollar has a strong inverse relationship with global investors’ measure and appetite for risk. As the US dollar strengthens, global investors tend to become wary of investing in riskier assets and would prefer to keep their assets in the safe-haven currency. As investors start to show signs of shunning risky assets, they tend to embrace proxies in the currency markets such as the Japanese yen and Swiss franc for bonds, as examples. Rising bond yields will make the US dollar more attractive to hold. Not surprisingly, currently, more than half of US Treasuries outstanding are held by foreign investors, including major central banks.
A strong US dollar will have a negative impact on international investment returns. Emerging markets, especially those with external financing vulnerabilities such as Brazil, Turkey and South Africa or other governments, companies and banks with large amounts of dollar-denominated debt commitments will endure more costs which might cripple their cash flows. This pressure can destabilise emerging markets with large currency mismatches, including what economists call the ‘original sin’, where countries borrowed heavily in US dollars but generate the bulk of the income used to service the debt (interest and maturity payments) in currencies that depreciate relative to the US dollar. In past recessions, fast-growing emerging markets have helped bail out the global economy, but history may fail to repeat itself if the US dollar strengthens too quickly. It will be hard for other emerging markets to step in and help salvage the global pandemic recession as long as the US dollar remains strong.
Back in the US, those companies that conduct a large portion of their business around the globe will suffer as the income they earn from foreign sales will decrease in value on their balance sheets. Investors in such companies are also likely to see a negative impact. As of the fourth quarter of fiscal year 2020, Apple Inc. (AAPL), the largest US company by market capitalisation, had close to 60% of its revenue generated outside of the United States. Apple’s total net sales amounted to around $64.7 billion in that quarter. McDonald’s Corp. (MCD) and Philip Morris International Inc. (PM) are also other well-known examples of US companies with a large percentage of their sales occurring overseas. While some companies use derivatives to hedge their foreign currency exposures, not all do, and those that do hedge may not be perfectly hedged.
Impact on US GDP will be noticed as visitors from abroad will find the prices of goods and services in the US more expensive with a stronger US dollar. Business travellers and foreigners living in the US but holding onto foreign-denominated bank accounts, or who are paid incomes in their home currency, will be hurt and their cost of living will increase. As imports become cheaper for the US, domestically produced goods become relatively more expensive abroad as a result of the expensive exports and ultimately lost US jobs. The impact of a rising US dollar on the earnings of US companies with large foreign operations can also be viewed from the S&P 500 companies with close to 30% of total sales coming from abroad; clearly a higher dollar, which cuts the dollar value of international revenues, is a drag on earnings.
The relationship between these two global prime market disruption candidates is striking. When US bond yields rise on the secondary market, the US government must pay a higher interest rate to attract buyers in future auctions. Over time, these higher rates increase the demand for US government bonds (Treasuries) and consequently increase the value of the US dollar. Equity valuations will decline as bond yields rise, with growth stocks mostly impacted as most of their cash flows which are usually far out in the future will be discounted at a higher rate. When bond yields notch higher, bond prices start to decline, meaning that the scope for further price depreciation increases while the scope for a price appreciation decreases.
Nevertheless, the US central bank has gone out of its way to assure markets that no such shifts are on the near-term horizon. However, a rapid rise in the US bond yields and a strong US dollar will both increase market volatility and tighten financial conditions. This might come at a tough time for the global economy as worldwide economic activity and trade are still suppressed by lockdown measures and slow vaccination.
Richard Maparura, CFA, is senior portfolio manager, Butterfield Group
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.