International factors could have a more significant role to play in South African financial markets in coming months, particularly those coming from the US. The US Federal Reserve should start to cut interest rates in the next few months, bringing welcome relief after more than a year of the highest interest rates the US has seen in more than 20 years. But while the economic dark clouds from high US interest rates might clear, new storm clouds loom in the shape of November’s presidential election.
The Fed has held interest rates at a high 5.5% since July 2023. If the Fed cuts rates in September, as we expect, it will have held the peak rate for 15 months. Bank of England chief economist Huw Pill said some time ago that the interest rate profile from the BoE would resemble Table Mountain and this has certainly been the case in the US as well, in addition to many other central banks, not least the South African Reserve Bank.
Reductions in US interest rates will not only benefit American borrowers but international borrowers as well. More than 60% of international bond issuance is denominated in the dollar with the euro far behind at about 20%. Similarly, about 50% of international bank lending takes place in the dollar and again, the next closest, the euro, is some way back on under 20%.
But lower US interest rates do not just bring benefits to those that borrow in dollars. If the fall in US interest rates weakens the dollar this can provide more scope for other countries to lower their own rates. In addition, falling US interest rates can improve financial market sentiment on a global level and encourage capital flows into emerging market assets.
This being said, US interest rates will not fall to the levels that we became accustomed to after the global financial crisis of 2008 and before the global surge in inflation in 2021. Extremely low policy rates from the Fed and others back then were caused by inflation that was too low.
Today’s problem is that inflation is still above target levels in the US and most other countries. Central banks will have to tread carefully and that’s likely to mean that the Fed reduces interest rates, not to near-zero levels as before, but to 3.5%-4%. Nonetheless, rate cuts will still bring global economic and financial market relief. Whether it will be sufficient to compensate for increased political risk remains to be seen.
Not long after the first Fed rate cut we could see political momentum in the US shift from Democratic Party President Joe Biden to the Republican Party hopeful, and former president, Donald Trump. Global financial markets are already on alert that a second Trump presidency could reignite inflation, force the Fed to reverse any pre-election interest rate cuts, and cause the dollar to surge. But is there any basis to these concerns?
It appears that there are three routes through which a change in US leadership could reignite inflation. The first is the prospect of new tariffs; this time an across-the-board 10% tariff on all imports and a much higher rate on Chinese imports, of 60% or more. Such threats may prove little more than political bluster but, if Trump’s first term was anything to go by, it should not be seen as an idle threat.
A second area of concern relates to migration. Many countries, including the US, have seen high levels of migration. But rather than take jobs from local workers, as is often the charge, they have expanded the workforce and helped prevent already-tight labour markets from generating even more inflationary pressure. Worryingly, a reversal of these inflows, as proposed by the Trump camp, could reignite wage and price pressure.
In short, the help to the world economy and global financial asset prices from Fed rate cuts could be undone by a change in political leadership in the US
And third, Trump wants to make the temporary personal tax cuts from 2017 permanent. This is likely to be dependent on the Republicans taking control of the Senate as well but, here too, lies a possible inflationary impetus and one that the Federal Reserve might have to combat with higher interest rates.
In short, the help to the world economy and global financial asset prices from Fed rate cuts could be undone by a change in political leadership in the US.
But nothing is certain. With monetary policy and political uncertainty elevated it seems likely that investors will sit on their hands and avoid making any rash decisions until the fog of monetary policy election uncertainty has cleared. This has been the way of things for some while now for both the dollar and US bond yields have been stable during this period when policy rates have been stuck at the top of Table Mountain. But with the cliff edge in sight, it won’t be long before international factors, particularly from the US, start to impinge on other countries such as South Africa. Will these international forces be positive or negative? We lean to the former outcome but are acutely aware that the stakes are high.
• Barrow is the Head of Standard Bank Research International
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.