by Chris Black
The dollar looks to strengthen much further and for much longer as the lagged impacts of monetary policy weigh on other major economies and compel their central banks to relent (cut rates) first in their restrictive (known as hawkish) policies.
Economic growth outside of the U.S. appears to be faltering as higher rates reduce disposable income via higher mortgage rates and also reduce the availability of bank credit.
At the same time, the U.S. economy continues to grow above trend and even potentially at an accelerating pace.
America’s use of long dated mortgages and reliance on capital markets financing (as opposed to bank financing) appear to make it relatively more resistant to higher rates.
This suggests that other economies will eventually cut rates earlier and more deeply than the Fed.
The lagged impacts of monetary policy are finally feeding through in some economies as borrowers refinance their mortgages at higher rates.
While the vast majority of U.S. mortgages are 30 year fixed rate, many other countries rely on either variable rate or short dated fixed rate mortgages.
U.S. borrowers are insulated from rate hikes both because they are not forced to refinance periodically and because changes in policy rates only indirectly impact longer dated rates. U.S. mortgage debt servicing ratios have thus remained around historical lows despite hikes due to robust wage growth (www.atlantafed.org/chcs/wage-growth-tracker) and a large existing stock of mortgages taken out at low rates (www.wsj.com/articles/low-mortgage-rates-home-sales-low-supply-899aab29).
In contrast, households in many other countries are beginning to see their disposable income disappear.
Mortgage payments are beginning to meaningfully impact households in economies where mortgages payments are more sensitive to policy rates.
Notable countries with this financing structure include Canada (www.bankofcanada.ca/2023/05/financial-system-review-2023/), Australia (www.rba.gov.au/publications/fsr/2023/apr/household-business-finances.html#:~:text=Total%20scheduled%20interest%20and%20principal,making%20over%20the%20past%20year.), the U.K. (www.ons.gov.uk/peoplepopulationandcommunity/housing/articles/howincreasesinhousingcostsimpacthouseholds/2023-01-09), and parts of southern Europe (www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2322~0ed0879d8a.en.pdf).
While variable rate mortgages have rapidly adjusted higher, short dated fixed rate mortgages (usually 2 to 5 years) are now gradually being refinanced at rates that can be twice as high as before.
Some borrowers may choose to extend their amortization period (www.bnnbloomberg.ca/some-canadian-mortgage-holders-extending-amortization-periods-by-more-than-double-expert-1.1934133) to avoid higher monthly payments, but others will cut back on discretionary spending to make the payment.
This is a clear channel of policy transmission that is slowing demand.
Tighter monetary policy has effectively reduced the supply of bank lending, which is likely impacting economies reliant on bank financing.
Higher policy rates reduce bank lending by raising the funding costs of banks, reducing available borrower collateral, and reducing bank risk tolerance (www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230712~d950906f00.en.html).
Aggregate banking data show a significant slowing in bank loan growth and tighter credit standards in many economies, including in the U.S. (fred.stlouisfed.org/series/TOTLL) and Euro area (data.ecb.europa.eu/main-figures/banks-balance-sheet/loans).
In most parts of the world, banks are the most dominant source of financing so less bank lending has a direct negative impact on economic activity.
While banks provide the bulk of financing in other countries, the capital markets are the largest source of financing in the U.S. Even U.S. consumer loans such as mortgages and auto loans are largely financed in the markets via securitization offerings.
The availability of market financing depends on factors that are different from bank financing, including the level of inflows received by institutional investors, mandate restrictions, or changes in an investor’s liability structure.
While bank lending has ground to a halt, credit is still available via the capital markets (www.bloomberg.com/news/articles/2023-09-05/september-flurry-of-fresh-corporate-debt-sweeps-global-markets).
This suggests that economies with developed capital markets, like the U.S., are avoiding more of the effects of tighter policy, and will thus be able to “out-hawk” other central banks by hiking further and holding higher for longer.
The U.S. has solidly out performed other developed countries over the past few years and appears to be growing at an accelerating rate:
Estimates of 2023 Q3 growth from the Atlanta Fed (www.atlantafed.org/cqer/research/gdpnow) and the New York Fed (www.newyorkfed.org/research/policy/nowcast#/nowcast/quarter/2023:Q3) point to above trend growth and slight acceleration.
In contrast, growth has been weakening in the Eurozone (www.bloomberg.com/news/articles/2023-09-07/euro-zone-gdp-barely-rose-in-second-quarter-amid-export-slump), Canada (www.bloomberg.com/news/articles/2023-09-01/canada-economy-slows-sharply-supporting-rate-pause), and U.K. (www.bloomberg.com/news/articles/2023-08-11/uk-economy-stronger-than-expected-after-coronation-holiday).
The difference in growth may in part be due to the relative effectiveness of policy in those countries , and suggests that policy in those economies will need to turn accommodative before it does in the U.S.
This would widen interest rate differentials in favor of the dollar.
Note also that the U.S. fiscal deficit remains high (www.bloomberg.com/news/articles/2023-08-24/bond-market-flashes-warning-as-us-budget-deficit-surges) both historically and in comparison to other countries and that is another reason for relative outperformance.
While major central banks set out together on their quest against inflation, they will likely be turning back at different points in time. The lags of policy depend on the structure of an economy’s financial system, and the U.S. is more resilient to higher rates than others.
The dollar strengthened significantly in 2022 as the Fed moved more aggressively than other major central banks, but sold off in October 2022 when other countries caught up.
The scenario may replay in a slightly different way as interest rate differentials widen because other central banks (like the Bank of England, who is nearing recession (www.theguardian.com/business/2023/sep/01/uk-recession-alert-big-falls-factory-output-house-prices-economy-bank-of-england-interest-rates)) pause and retreat first.