The broadside Moody’s Investors Service just fired at the US dollar and interest rates dramatizes why the next few months could be uniquely chaotic for global markets.
It stands to reason that the one major credit rating company still holding Washington in AAA esteem is anxious to announce a downgrade.
Twelve years after S&P Global downgraded the US, Fitch Ratings last month followed suit. Fitch’s move was about more than America’s national debt careening toward US$33 trillion.
It was also a response to the “steady deterioration in standards of governance” as politicians play games with raising Washington’s statutory debt limit.
Now, Moody’s warns that the dysfunction surrounding a government shutdown on October 1, the latest manifestation of extreme polarization, may be the reason to cut Washington’s rating to Aa1.
Investors seem way ahead of credit rates as US yields move higher. Rates on 10-year Treasury bonds are at a 16-year high this week, a dubious milestone that’s slamming European and Asian markets. Benchmarks from Japan to South Korea to Australia plunged.
On Tuesday alone, MSCI’s gauge of global stocks plunged 1.24%, an outsized move for the benchmark. By Wednesday, the index was falling for a ninth day as it approaches its longest losing streak in more than a decade.
The Cboe Volatility Index, Wall Street’s so-called fear gauge, flashed its most intense warnings since May, when US inflation hit a 41-year high.
Adding to the disorientation is the dollar’s curious durability. The more investors fret about the state of global finance, the more the dollar rises. The yen’s move toward 150 to the dollar, a psychologically important level, has markets bracing for currency intervention by Japanese authorities.
The US Federal Reserve, meanwhile, is making it clear it’s not done hiking rates. When Minneapolis Fed President Neel Kashkari on Tuesday assigned 40% odds that rates will still go “meaningfully” higher, traders figure policymakers are telegraphing more austerity to come.
Already, 11 Fed tightening moves in 18 months are working their way through global markets. The specter of more hikes could wreak havoc in debt markets, equity bourses and property sectors everywhere.
Europe is uniquely poorly positioned to withstand the coming financial storm. Rising yields will hit real estate values from Tokyo to Seoul to Bangkok.
A major challenge for Asia is figuring out which financial shoes might drop next as well as how and where the tremors will be felt.
The US government shutdown for which Republican lawmakers are agitating would furlough hundreds of thousands of federal workers and suspend vast swaths of public services, crimping US economic growth.
“A shutdown would be credit negative for the US sovereign,” Moody’s analysts wrote in a note this week. They argue that “it would underscore the weakness of US institutional and governance strength relative to other AAA-rated sovereigns that we have highlighted in recent years.”
In particular, Moody’s adds, “it would demonstrate the significant constraints that intensifying political polarization put on fiscal policymaking at a time of declining fiscal strength, driven by widening fiscal deficits and deteriorating debt affordability.”
Economists at Wells Fargo write that “should a shutdown transpire, there could be a negative impact of the US dollar, albeit one that is likely to be modest and short-lived.”
Gita Gopinath, first deputy managing director at the International Monetary Fund, warns of “tougher global financial conditions.” As the “fight to bring inflation back to target continues,” Gopinath says, “we expect global interest rates to remain high for quite some time,”
Furthermore, she notes, “there are reasons to think that rates may never return to the era of ‘low for long.’ This possibility is reflected in US 10-year Treasury bond yields, which have surged” to the “highest level since the global financial crisis.” In this environment, Gopinath says, “financing conditions for emerging markets can be expected to remain challenging.”
Analyst Gennadiy Goldberg at TD Securities says “overall, we view the shutdown as one of the many headwinds the economy faces this fall.” Analyst Michael Pond at Barclays tells Bloomberg that a government shutdown “will likely lead to some heightened uncertainty,” given how vulnerable Asia’s export-led economies are to “hot money” flows.
Shutdown risks are coinciding with surging oil prices and a massive strike by Detroit auto workers, both of which are exacerbating inflation risks. As such odds are Fed Chairman Jerome Powell’s team will hit the monetary brakes even harder.
Count Jamie Dimon, CEO of JPMorgan Chase, among those who believe Fed rates – in the 5.25%-5.5% range now – could go significantly higher as inflation remains elevated.
“I am not sure if the world is prepared for 7%,” Dimon told the Times of India. “I ask people in business, ‘Are you prepared for something like 7%?’ The worst case is 7% with stagflation. If they are going to have lower volumes and higher rates, there will be stress in the system. We urge our clients to be prepared for that kind of stress.”
What’s more, Dimon referenced Warren Buffett’s famous observation that “only when the tide goes out do you discover who’s been swimming naked.” As Dimon notes of more assertive Fed tightening moves, “that will be the tide going out.”
“Investors,” says analyst Paul Nolte at Murphy & Sylvest Wealth Management, “are beginning to realize that a higher for longer interest rate environment is a likely outcome and are slowly adjusting to the new normal. Higher-for-longer has been the mantra of the Fed for a few months. It is only recently that the markets have been taking them at their word.”
The irony, of course, is that the worse things get for the US fiscal outlook, the more investors flock to the dollar. That’s luring capital away from China, Japan, South Korea and other top Asian economies at the worst possible moment for Beijing, Tokyo, Seoul and beyond. Counterintuitively, big losses in US sovereign securities are increasing the dollar’s appeal.
Even before Moody’s stumbled onto the scene, global investors faced the specter of a third straight year of losses in the $25.5 trillion Treasury debt market. All the red ink reflects investor concerns about liquidity amid the most aggressive Fed tightening cycle since the mid-1990s and extreme volatility as inflation flares up across the globe.
Yet from an interest rate differential standpoint, says Nomura Inc strategist Andrew Ticehurst, the dollar’s legacy safe-haven status, America’s steady growth and high yields make for an “unusual and powerful combination” at a moment when the potential for sudden risk-off pivots abound in markets.
Another reason this appears to fly in the face of both political and financial reality: US President Joe Biden’s dismal approval ratings. As Congressional Republicans and Democrats lock horns, Biden’s low-40s support rate leaves the White House little hope of cajoling lawmakers not to shut down the government, gamble with Washington’s credit rating or pursue reforms to increase US innovation and productivity to tame inflation.
The same goes for Biden’s latitude to protect the roughly $3.2 trillion of US Treasury securities held by top Asian authorities. Those foreign exchange reserves could find themselves in harm’s way as Moody’s joins S&P and Fitch in closing the books on America’s AAA era.
Japan would be the biggest loser with its more than $1.1 trillion of US government debt. China holds $821 billion and Korea has $116 billion. Along with losses on state savings, surging US rates could devastate Asia’s biggest trade-reliant economies, each of which is navigating their own domestic debt troubles.
In China, it’s property markets and a titanically large shadow-banking sector. In Japan, it’s the most crushing debt load in the developed world made worse by a fast-aging population. In Korea, it’s record household debt undermining broader consumption dynamics.
Here, the dollar’s trajectory – and how its rally defies gravity as bonds sell off – is adding to Asia’s headaches.
Economist Jeongmin Seong at the McKinsey Global Institute says that “many Asian countries accumulated substantial foreign exchange reserves after the Asian financial crisis of the late 1990s.” In 2022, he notes, Asia accounted for 40% of global capital flows, four times the level in 2000.
“But there may be pockets of vulnerability to any sudden outflow of capital,” he explains. “In Indonesia and Vietnam, for instance, foreign direct investment accounts for 20% and 14% of total investment, respectively.”
Episodes of runaway dollar strength tend to end badly for Asia. Look no further than the region’s 1997-98 financial crisis, which was precipitated by the US Fed’s aggressive 1994-1995 rate hike cycle.
Episodes of yen volatility pose their own threat. Worries about surging Japanese government bond yields are rippling through global credit markets as the Bank of Japan hints at an exit from quantitative easing. That poses outsized risks because 24 years or zero-to-negative rates morphed Japan into the globe’s premier creditor nation.
These funds are then invested in higher-yielding assets from Brazil to South Africa to Indonesia. This giant “yen-carry trade” often explains why sharp yen moves often slam markets everywhere.
IMF economist Thomas Helbling says Asia is highly exposed on account of debt levels. “Asia’s increased borrowing in recent decades has augmented the region’s exposure to rising interest rates and heightened market volatility,” Helbling explains. “Borrowing by the region’s governments, companies, consumers and financial firms is well above levels prior to the global financial crisis.”
Trouble is, Helbling says, “highly leveraged companies face greater risk of default as monetary policies and financial conditions remain tight. Even with resilient economic growth, interest payments may exceed earnings as borrowing costs rise, reducing firms’ ability to service their debts.” Generally speaking, he adds, “corporate debt in Asia is concentrated in firms with low-interest coverage ratios.”
McKinsey economist Seong says that “some Asian economies, government, household, and corporate debt has risen by even more than the Organization for Economic Cooperation and Development average.”
Seong points out that nonfinancial corporate debt in China is 150% and in Japan, South Korea and Vietnam it is more than 120%. In 2021, Korea’s household debt reached 106% and Australia’s was 119%, against an OECD average of 60%. “Carrying this amount of leverage will be costly if interest rates continue to rise,” Seong notes.
On the property side, “there’s is a risk of a fall in asset prices, including real estate,” Seong says. Between 2015 and 2021, the average nominal housing price rose by 50% in China, 34% in Australia, and 17% in South Korea. Price inflation in cities is even higher. In Seoul, for example, the price-to-rent ratio increased 2.5 times in the 2015-2021 period.
At home, Biden also must ensure the stability of banks as Fed rate hikes continue. Mohamed El-Erian, advisor at Allianz, worries higher borrowing costs may cause havoc in real estate markets. “We’ve got to be really careful,” El-Erian warns. “The housing market is central to the economy.”
At the same time, the fallout from the collapse of Silicon Valley Bank in March “is casting doubt on America’s ability to maintain its leadership of the global monetary system,” notes economist Diana Choyleva at Enodo Economics. It’s up to Washington “to take decisive steps to shore up confidence, including extending dollar credit lines to a clutch of Asian countries.”
As Choyleva stresses, “it is in Asia that the United States’ global financial hegemony is being most keenly contested – by China.”
It’s hard not to think Washington’s shutdown showdown is doing Beijing’s work for it.
Follow William Pesek on X, formerly known as Twitter, at @WilliamPesek