As best defined by sociologist Robert K. Merton in 1936 “Unanticipated consequences from purposive social action, particularly taken on a large scale by governments, may have unexpected consequences.”
“Investors have come to count on central banks to keep the game going but [these actions] engender moral hazards and ultimately relies on wishful thinking. ” Claudio Borio, Bank for International Settlements (1). When the Fed decides to raise rates, be it this December or early in 2016, it will be first time since 1994 that the U.S. raises its rates and the European Central Bank cuts theirs.
What followed in the 1994 rate increase was not anticipated by then Federal Reserve Chairman, Alan Greenspan (2). In 1994 the US economy was emerging from recession and US Treasury yields were rising slightly from 1993 lows as economic growth outlook was improving. Though no other signs of inflation emerged. Alan Greenspan and the Fed surprised the markets by tighten monetary policy. Treasuries plunged as interest rates raced higher throughout the remainder 1994 and set up a fixed income market bloodbath, best exemplified in December 94 $110 million Orange County California bond default or Mexican peso crisis (3,4).
And what will be the unintentional consequence of our impending first US interest rate increase?
Increased currency carry trades
As US interest rates increase there may be a flood of foreign currency into the US market to drive the US dollar even higher from its already lofty position. Investors will likely take advantage of the interest rate differential increase currency carry trades. In this scenario an investor will sells euros with their current low (i.e. negative) yields to buy US Treasuries or US financial assets (stocks or company bonds). Such demands for higher yields and concurrent asset purchases will further inflate the stock and bond bubble that is already started from earlier rounds of qantitative easing. As further proof that the bubble pop is coming soon, investors are already ignoring company fundamentals which are and have remain weak these last seven years (5).
As added proof of this new trend in currency swaps, American companies are issuing securities in euros in record volumes – these so-called ‘reverse yankee bonds’ which have doubled in issuance to $93 billion – to take advantage of lower rates in Europe, and are making an implicit bet that the euro will weaken further.
Emerging market and China US debt:
With easy fed monetary policies debt:GDP ratios are now significantly higher across the globe compared to 2007 and the financial crisis and makes the financial system acutely vulnerable to monetary tightening by the US Federal Reserve. Combined public and private debt in developed and emerging market countries has jumped sum 265 % and 167 % of GDP, respectively.
China’s debt to GDP has spiked more than its smaller neighbors to 235 % of GDP. Adding to these national debts is additional off-shore business US denominated business loans to the sum of $3 trillion, 80 % of which is held by Chinese companies as short-term loans. Since these loans must be repay in US dollars, the rise in US interest rates rise, combined with concomitant US dollar strengthening will set the stage for a worldwide dollar liquidity crisis. As nations use up their US reserves to support their own currency exchange rate or business try to repay their ballooning US debt in weak home currencies, we will see events similar to the 1994 Mexican peso crisis or increased business closings and bankruptcies.
- US interest rate rise could trigger global debt crisis Global debt levels are dangerously high and central banks cannot keep the game going indefinitely, warns the high priest of orthodoxy. http://www.telegraph.co.uk/finance/economics/11858952/BIS-fears-emerging-market-maelstrom-as-Fed-tightens.html
- The ‘1994 Moment’ Is Keeping More And More Bond Traders Awake At Nighthttp://www.businessinsider.com/1994-federal-reserve-tightening-story-2013-1
- Orange County was forced to file for bankruptcy after it was unable to roll over a $2 billion loan with the CS First Boston Corporation. The action followed the disclosure that the county’s investment fund had lost more than $1.5 billion because of interest rate bets that went bad. http://www.nytimes.com/1994/12/09/business/a-default-by-orange-county.html.
- The Mexican peso crisis (also known as the Tequila crisis) was a sparked by the Mexican government’s sudden devaluation of the Mexican_peso against the US dollar in December 1994 and is known as one of the first international financial crises ignited by capital flight. Mexico’s economy experienced a severe recession as a result of the peso’s devaluation and the flight to safer investments. The country’s GDP declined by 6.2% over the course of 1995 https://en.wikipedia.org/wiki/Mexican_peso_crisis.
- Data be damned, Wall Street says all is well. http://finance.yahoo.com/news/data-damned-wall-street-says-192750428.html#