In the early morning of September 17th of this year, Korean time, the U.S. Federal Reserve System (hereinafter referred to as the Fed) raised its benchmark interest rate for the first time in three years and two months. The federal funds rate, the US benchmark interest rate, has now increased to 3.75-4.0%.
Even though the Federal Reserve raised interest rates, the financial market's reaction was relatively calm. U.S. long-term government bond interest rates have actually shown a downward trend, and major U.S. stock indices such as S&P 500 and NASDAQ are also showing strength, approaching all-time highs.
Asian stock markets such as Korea, Japan, and Taiwan also showed a rebound immediately after the U.S. interest rate increase. The reason why the financial market was not greatly shaken is because this increase was more of an afterthought to the already existing increase in market interest rates rather than the beginning of new austerity measures.
Normally, when the central bank moves the base interest rate, the market interest rate reflects it, but now the order has changed. Even before the Federal Reserve raised its benchmark interest rate, long-term interest rates in the United States were rising rapidly.
During the Fed's aggressive tightening in 2022-2023, the base interest rate rose to 5.25-5.50%, and the highest interest rate on 10-year U.S. Treasury bonds was 4.99%. Although the current base interest rate is about 1.5 percentage points lower than then, the 10-year government bond interest rate has already exceeded 5%, and the 30-year government bond rate has also risen to the 5.3% range, exceeding the peak in 2023.
Long-term interest rates rose despite the prevailing view that the base rate would be frozen until the Jackson Hole Conference at the end of August this year. This is why it is difficult to explain the recent rise in interest rates solely through the Federal Reserve's monetary policy.
The fundamental force driving up long-term interest rates is concerns about the U.S. government's fiscal deficit and growing debt. In August of this year, the U.S. national debt exceeded $40 trillion for the first time in history. There is no change in the fact that U.S. Treasury bonds are the safest assets in the world, but if debt continues to increase, investors will have no choice but to demand higher interest rates in return for lending money to the U.S. government.
Here, the variable of the Middle East war was added. The war between the United States and Iran affects interest rates through two channels. One is Yuga. International oil prices exceeding $100 per barrel are raising inflation expectations.
The other is finances. As the war lasts, war spending increases and the fiscal deficit widens. To absorb the growing supply of government bonds, investors demand higher interest rates. Inflation risk and financial risk are simultaneously reflected in long-term interest rates.
One of the Federal Reserve's most important responsibilities is price stability, but the recent rise in prices is difficult to control simply by raising interest rates. The consumer price index (CPI) in August rose 3.4% compared to the same month last year, but the core CPI increase rate excluding food and energy was 2.4%.
If a significant portion of the recent price increase is due to a surge in energy prices, if the Federal Reserve adopts overly aggressive tightening, it may damage the economy without sufficiently lowering prices.
However, the burden of high interest rates cannot be taken lightly. U.S. government debt exceeds 120% of gross domestic product (GDP), and companies' financing for investment in AI (artificial intelligence) infrastructure is also increasing significantly.
In this situation, if long-term interest rates remain in the 5% range for a long time, the interest burden on the government and companies will inevitably increase. High interest rates in the United States, a reserve currency country, also have a tightening effect on the global financial environment. Just because the financial market reacted calmly to the Federal Reserve's interest rate hike does not mean that the risk of high interest rates has disappeared.
There is also a possibility of a reversal. If the main driving force behind the recent push in interest rates is the war in the Middle East rather than the Federal Reserve, the changes that will occur when the war ends may also be significant.
If international oil prices fall, concerns about inflation will ease and the need for additional tightening by the Federal Reserve will also decrease. If the burden of war expenses is reduced, concerns about the U.S. fiscal deficit and government bond supply may also ease. Even if the Federal Reserve does not lower the base interest rate, long-term interest rates can fall first and the financial environment can ease quickly.
It is difficult to predict when the war will end. However, it is clear that a protracted war will place a significant burden on both the United States and Iran. As long as the war continues, high oil prices and high interest rates will remain as factors weighing down the global economy and financial markets, but if the end of the war becomes a reality, the situation may develop in the opposite direction.
As oil prices and interest rates fall together, there is the possibility of a strong global liquidity rally. Ultimately, this is the Trump administration's time rather than the Fed's. The key variable that will determine the direction of the global financial market in the medium term will not be the Federal Reserve's next interest rate decision but the end of the Middle East war.
Kim Hak-gyun, Head of Research Center, Shinyoung Securities
