This is an excerpt of the August 2013 Longbrake Letter. To read the letter in its entirety, click here.
We tend to think that U.S. economic activity and financial markets are driven exclusively by what happens within our own borders. In an increasingly interconnected world that is a gross oversimplification. What happens in the U.S. affects what happens in other countries and what happens there, in turn, feeds back into the U.S. economy and financial markets. The recent sharp increase in long-term interest rates has been a global phenomenon. Financial conditions tightened not just in the United State but around the globe as well.
For example, a relatively immediate consequence of higher interest rates in the U.S. has been an increase in the value of the trade-weighted dollar. This will make U.S. exports less attractive and could have negative consequences for U.S. manufacturers over time. Ordinarily, the mirror reflection of this phenomenon would be favorable to foreign exporters. But this is not true for countries that have tied the values of their currencies to that of the U.S. dollar.
From a financial markets perspective, the long period of low nominal interest rates and negative real interest rates in the U.S. spawned “carry trades” in foreign currencies, particularly those of emerging economies. But, as interest rates have spiked in the U.S. real yields have gone from -0.6% to +0.6% and made the carry trade much less attractive financially.
This has occurred at the same time as it is increasingly apparent that the Chinese economic model really is in transition to more of a consumer focus and less of an investment focus. Emerging economies have benefited enormously over the last several years from insatiable Chinese demand for commodities. That demand has now subsided as indicated by falling prices for commodities. Thus, growth prospects have changed dramatically for the worse for those economies heavily dependent on China.
Put both sets of developments together and the result is massive reversals in the flows of hot money. Indonesia and India will be severely impacted because both countries run large trade deficits and are highly dependent upon favorable capital flows which are now drying up. Consequences for these two countries will involve slower economic growth and higher inflation. India’s central bank has been forced to defend its currency by raising short-term interest rates. As a result the yield curve has inverted. At the very least it appears that growth will slow substantially in India just as it did in Brazil earlier this year.
Emerging economies with large trade surpluses are not dependent upon capital inflows but their economies tend to be tightly tied to the strength of China’s economy and those of developed countries. China’s economy is slowing; in spite of optimism about the end of recession in Europe, this remains a glimmer in the eyes of the beholder; and in the U.S. the apparent acceleration in economic activity may fall short of expectations as tighter financial conditions and a more expensive U.S. dollar depress U.S. domestic demand and as slower foreign economic growth causes negative feedbacks for U.S. economic activity.
This is not yet a gloom and doom scenario. In other words, a deflationary bust is not yet inevitable. But, U.S. economic activity needs to accelerate to support other global economies. If U.S. growth falls short it doesn’t appear that any other country or countries are positioned to pick up the slack.
Remember from the experience of the mid-2000s that risks can be hidden from view and appear to be minimal. But the accumulating underlying economic and financial market imbalances slowly and inexorably build until the dam bursts. This is not to assert that we are approaching such a moment once again. But, it is to suggest that caution is warranted.