Why the Economy Is Proving More Resilient to High Interest Rates Than Expected

Despite fears of recession amid rising global interest rates, the U.S. example shows that growth and high rates can coexist—at least for now.

The yield on the 10-year U.S. Treasury note recently hit 5.35%, its highest level since April 2002. This has led several economists to worry that the increase could eventually trigger a severe recession. Yet on Wall Street, everything is calm. The S&P 500 and the Nasdaq have even reached all-time highs, and the U.S. economy is growing faster than expected. Normally, rising U.S. Treasury yields weigh on stock prices. Higher yields push up the risk-free rate and make borrowing more expensive for both companies and consumers, whose spending drives the economy. That typically slows growth and drags down market capitalizations.

But for now, none of that is happening. “The sensitivity of the economy and equity markets to interest rates has decreased, and 10-year U.S. yields above 5% are not yet a major threat to the bull market in stocks,” notes investment advisory firm BCA Research in a report published Wednesday, October 14.

Small and large companies are still weathering higher rates

Not only are large companies continuing to outperform, but even small businesses do not yet appear to be affected by rising rates, according to BCA Research. “Despite a significant increase in bond yields, there has not been a notable rise in the number of small businesses citing financing conditions or interest rates as their main problem,” the report says, while conceding that the impact could be delayed.

“In 2021 and 2022, the effect of rising rates only showed up with a lag, and small businesses may only now be starting to feel the impact of the current increase in yields,” the report adds. Economist Paul Krugman, who is not known for pulling his punches against Donald Trump’s economic policies, argues that the main reason for higher interest rates on U.S. debt is not a crisis of confidence, but rather a strong appetite for credit driven by massive investments in AI. This is leading hyperscalers to take on more debt, and, according to Krugman, higher energy prices following the war in Iran are also a factor.

How things could go south

If rising rates are not causing panic for now, it’s also because they currently coincide with a U.S. economy that continues to perform well. Record investments, especially in AI, show that companies still have confidence. According to FactSet, analysts estimate that S&P 500 company earnings rose 29.5% in the third quarter, which would mark the third consecutive quarter of growth above 25%.

However, things could deteriorate if future indicators undermine confidence in the U.S. economy. For example, if the third-quarter earnings season, which has just begun and for which investors are currently very optimistic, turns out to be disappointing. Or if AI gains take longer to materialize, eventually casting doubt on the record investments tech giants have made in the technology.

That could set the stage for a scenario reminiscent of the telecom bubble. Investors might realize that hyperscalers have added too much computing capacity and that their stock prices are no longer justified, triggering a financial crisis that could spill over into public finances—especially since U.S. economic growth is currently being driven largely by AI. A small group of chip and hardware manufacturers is benefiting from massive investments in a still-nascent technology, and those investments are coming from an even smaller group of hyperscalers. It’s a highly concentrated growth engine, and therefore a fragile one.

The unique situation in France

It’s also important to distinguish the situation in the United States from that in France. Unlike what is happening across the Atlantic, the rise in interest rates on French debt is mainly due to a lack of confidence in its sustainability. Public finances continue to deteriorate, and France is experiencing sluggish growth.

“The rise in French government bond yields is largely explained by a heightened perception of the risk that France could default on its public debt,” writes Paul Krugman in a recent post. “Debt is already at a very high level as a percentage of GDP, and the French government keeps adding to it by running large budget deficits, even though there is no emergency—such as a war, a severe recession, or a pandemic—to justify them. In addition, the French population is aging, which means that, all else being equal, pension costs will rise much faster than revenues,” the economist explains. The rise in rates in France is therefore more concerning than in the United States. 

This article was automatically translated from French. Read the original version: https://www.journaldunet.com/business/action-publique/1556871-pourquoi-l-economie-est-plus-resiliente-aux-taux-d-interet-eleves-que-prevu/