What would it take to put the global economy into a tailspin?
The Bank of America, which is worth roughly $US275 billion ($395 billion), and dependent to a degree on functioning financial markets, is asking itself that question.
The answer lies in the cost of debt.
Low productivity, excess demand, the boom in artificial intelligence and the Iran war are all pushing up the cost of borrowing.
Despite this, interest rate increases have not yet done too much damage to share markets, property prices, or indeed many advanced economies.
But the Bank of America’s head of interest rates strategy, Mark Cabana, has estimated the cost of borrowing, or level of interest rates, that would cause financial damage.
He says we’re not far from that point.
Interest rates are still benign
The Federal Reserve is the US equivalent of Australia’s Reserve Bank.
Bank of America’s Mark Cabana says interest rates are “not restrictive” enough. (Supplied)
It recently raised America’s benchmark interest rate by a quarter of a percentage point, to a range between 3.75 per cent and 4 per cent.
The trillion-dollar question many central banks are asking themselves is what interest rate level will work to lower overall demand in the economy?
And crucially, when does the cost of borrowing become financially dangerous?
Mr Cabana, who was previously an analyst at the New York Federal Reserve, said the recent US bond market sell-off had led to yields rising to multi-decade highs.
He also said the sell-off was not severe enough to cause steep falls in asset prices.
Bond yields rise when their prices fall.
Yields also rise ahead of increases to central bank interest rates.
“We expect that rates will continue to rise and that the curve will continue to flatten in the US, but also likely globally, simply because the level of interest rates today is not restrictive,” Mr Cabana said.
Put simply, Mark Cabana does not believe US interest rates are currently high enough to significantly slow economic growth
“And what that means is that interest rates have not risen high enough to actually see any type of slowing in macroeconomic data.
“So it seems like the market is generally comfortable with the extent of the rate move thus far.”
US interest rates heading higher
Goldman Sachs has pushed its forecast for the next US interest rate hike to December.
Bond market screaming economic trouble ahead
It did this after a softer-than-anticipated inflation reading last week cooled expectations the Federal Reserve would hike rates again in October.
A December rate hike would push the fed funds target to 4 per cent to 4.25 per cent.
This interest rate level, Mark Cabana believes, is approaching the economic and financial danger zone, with greater concerns if expectations push into the high 4s and mid 5 per cents.
“That might be more consistent with some signs that we start to see a tightening of financial conditions and slowing in macroeconomic growth,” he said.
Interest rate tipping point
Australia is already seeing a cooling of the housing market, and the share market is also well off its August highs.
The Australian government’s 10-year bond yield — or the interest rate it needs to pay to borrow money for a decade — has risen to its highest level since 2011.
All working Australians would be mindful of this because it has direct implications for their superannuation balances.
Mr Cabana recently visited Sydney to, among other things, address the nation’s superannuation heavyweights.
“I know that they are extremely focused on this question as well [of when interest rates will be restrictive to growth],” he told The Business.
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Australian superannuation funds have tens of billions of dollars’ worth of Australian workers’ cash tied up on Wall Street, including the big tech companies.
“Our guidance to them would be that they should become much more concerned if you do see that macro data continues to be strong and that financial conditions are not showing signs of caring.”
Put simply, Cabana is saying that if the US economy continues to grow, and inflation pressures persist, US interest rates will need to push higher.
“That will mean that [US interest] rates may need to rise further and rates that have a 5 per cent or 5.5 per cent level.”
Inflation worry is front and centre
Others see more leg room for asset prices to stretch out.
VanEck’s investment strategist Anna Wu believes the investment boom underway, particularly in relation to artificial intelligence (AI), will overwhelm any short-term financial market gyrations.
“Past rate hiking cycles have taught investors tough lessons, especially 2022, when the Fed lifted rates from near zero to above 4 per cent in nine months, and to above 5 per cent by mid-2023,” she said.
“Equities fell because rising rates hit valuations before company profits could catch up.”
Anna Wu is a cross asset investment strategist at Van Eck. (Supplied)
Ms Wu believes this time is different.
“We are in a slightly different regime now,” she said.
“Bond markets expect inflation to stay around its five-year average.
“That means US yields are rising largely because investors expect stronger growth, not runaway prices.”
Anna Wu draws the distinction between inflation worries and interest rates responding in a healthy way to the growing US economy.
“Investors should be risk aware,” she said.
But as Reserve Bank governor Michele Bullock put it last week, when asked if the RBA would need to push the economy into recession to achieve its inflation target, ” I guess possibly.”
She added that, “The scenario that I’m thinking of there is if inflation expectations get away from us.
“If that gets away, then that is a circumstance in which I think you might need to have quite a dramatic slowdown in the economy to — and that’s our worry,” Ms Bullock said.
It’s clearly something Mr Cabana and the Bank of America are worried about too.
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