Chief Economist & Senior Portfolio Manager, Switzerland, SYZ Group
Higher Interest Rates Increase The Risk of an Accident on Public Debt
Interest rates have sharply risen in the past three years, with short-term rates raised to their highest in twenty years and long-term rates up to heights not seen in more than a decade. This sharp increase in financing costs has hit all economic agents, from governments to businesses and households. In a world mired in an ever-growing pile of debt -USD 315 trillion in aggregate, such a change in interest rates is a dramatic development that has some immediate impacts on the economy. Other effects of higher rates would only unfold over time. In that respect, it is key to understand the drivers of the recent surge in rates, and it is even more important to assess debt sustainability risks caused by higher financing costs.
A “Normalization” in Rates since 2022 after an “Abnormal” Decade of Low Rates
After falling to historical lows during the Covid pandemic, global interest rates have sharply increased in the ensuing three years. Disruption in global supply chains, combined with a burst in consumer demand fuelled by unprecedented government spendings, have suddenly revived inflationary pressures that had been asleep since the 1990s. Central banks reacted by raising short-term rates in panic mode, and all interest rates adjusted to this new environment by reaching levels not seen in at least a decade. This movement was a shock, for the magnitude and for the speed of the adjustment.
A Sharp Upward Adjustment in Debt Rates for Governments and Corporations
The Direct Impacts of Higher Debt Rates
The sharp increase in interest rates has had direct and immediate effects on several segments of the economy. The real-estate market was bluntly impacted. Its high sensitivity to financing conditions, coupled with a sudden decline in demand caused by the rise of Work-from-home, led to a collapse in prices and transaction volumes for offices and other commercial real estate. Since most households’ mortgages are on fixed-rate terms, the impact on the residential real estate market was different: the rise in mortgage rates to a 20-year high resulted in a “freeze” of the market, a collapse in transaction volumes, with total home sales in the US falling by a third from their 2021 level. However, prices barely adjusted and even resumed a mild upward trend due to a scarcity of available housing on the market. Business investment was also affected by the rise in financing costs, but the impact was less negative as solid profit growth and fiscal support helped to cushion the blow. For the government, the impact was also very visible: net interest payments of the US government have more than doubled since 2021.
A Surge in Mortgage Rates and in Government Interest Payments
Sustainability of “Higher” Rates in a “High Debt” World?
Beyond those immediate impacts, a higher level of financing cost questions long-term financial equilibriums in a highly indebted world. While rates are “only” back to levels prevailing in the early 2000’s, the economic conditions are significantly different today. From 2000 to 2007, public deficits averaged 2%-to-3% of GDP in Western economies. They have generally exceeded 6% since 2020 and total public debt represents more than 100% of GDP in most economies. Rate levels that were sustainable twenty years ago can be more problematic to cope with in that context. In fact, the current situation can be sustained for governments provided one key condition is met: nominal GDP growth must be higher than the public deficit and the rise in debt interest payments. This is what has happened since 2021, when a combination of strong real economic growth and inflation allowed debt-to-GDP ratios to stabilize despite large public deficits. But this leaves governments at the mercy of an economic growth slowdown that would suddenly make the debt situation much more worrying.
High Government Debt can be Sustained if Nominal Growth is High.
Interestingly, the problem discussed above is much less acute for the private sector. Indeed, household debt relative to GDP has been declining in the past 15 years. Corporate debt relative to GDP has been declining recently and is back toward its 30-year average. Higher interest rates can certainly be a headwind for private sector’s investment and spending going forward, but they are not the same threat to debt sustainability that they are for governments.
The risk of an accident increases with high interest rates and growing debt levels.
The magnitude and speed of the recent increase in debt rates have exerted some stress on rate-sensitive sectors, but they haven’t so far derailed economies from their growth path. However, the question remains open on the medium and long-term impacts of those higher rates, especially for the sustainability of government debt. This may push governments to keep supporting economic activity, and central banks to tolerate somewhat higher inflation down the road to ensure that nominal growth remains strong enough. But the risk of an “accident” on government debt has clearly increased and will keep rising.
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