Markets were spooked this week by troubles in both the UK and China. The UK launched a program to boost the economy through a combination of tax cuts and spending. Under the terms of the program the government would subsidize energy costs for UK households, capping the total costs at £2,500 per year for the next two years. Economists feared that, without intervention, rising energy costs in Europe would drive average household energy bills to £3,500 this year and as high as £6,000 next year. The government was clearly trying to avert crisis as skyrocketing energy costs hurt consumers.
Unfortunately, the market was not impressed with the large deficit spending plan, which would result in the government borrowing more than £190 Billion. In essence, markets worried that the government spending would result in even more inflation and require the Bank of England to raise rates even faster. Interest rates in the UK spiked and the Bank of England was forced to step in to avoid a crisis. Some British banks have stopped issuing mortgages until interest rates calm down. The pound fell sharply against the dollar.
China is also having a debt problem as China’s troubled real estate sector continued to deteriorate. Real estate, which some economists estimate to be 20% of China’s GDP, had been a key driver of growth for decades. Unfortunately, the real estate boom has resulted in literal ghost towns of empty residential buildings. Chinese developers, notably Evergrande and Sunac China have defaulted on billions of dollars in debt. Average new home prices in China continue to fall and the Chinese Yuan continues to fall against the US dollar.
The key theme is that rising rates in the U.S. are starting to put strain on international markets. As US interest rates rise, money flows to the US dollar, attracted by the potential to earn more in U.S. bonds. Conversely, the value of international currencies, such as the British Pound and the Chinese Yuan, fall. Since the price of oil, many international bonds, and many other contracts around the world, are denominated in U.S. Dollars, the dollar’s strength can be big problem.