US Interest Rates and the Cost of Borrowing for Emerging Economies

With the first signs of decelerating inflation in the United States, countries in Latin America and the Caribbean are probably asking themselves when borrowing costs will fall again. Lower inflation rates in the US, after all, could allow the Federal Reserve to end its cycle of rising interest rates sooner than expected and start eventually reducing the Fed Funds Rate (its monetary policy rate and the interest rate US banks charge each other to lend funds overnight).

But a lower Fed Funds Rate may not necessarily play that big of a role for our region over the next few  years. Even if it reduces interest payments on new debt issuances at this moment of large fiscal deficits and debt levels, its direct effects are likely to be mild at best.

Countries in this context would do well to keep focusing on bolstering their fundamentals: improving fiscal balances, reducing debt levels, and seeking policies to promote growth.

Countries that issue bonds in foreign markets are charged a spread over a benchmark rate. For dollar-denominated bonds, the benchmark is usually the interest rate on US government securities of similar maturity. An increase in the Fed Funds Rate represents a direct increase in the short-term benchmark rate, and may also increase the long-term benchmark rates.  In turn, investors may demand a larger premium in the face of the underlying risks associated with higher benchmark rates, leading to an increase in spreads as well.

Short and Long-Term Rates Don’t Necessarily Move Together 

Figure 1a shows the evolution of the Fed Funds Rate and the 10-year yield on US Treasury Notes over the last 25 years. It shows that the long-term rate does not always move together with the short-term one. Take, for example, the period between 2009 and 2019. We observed sizeable variations in the long-term rates while the (short-term) policy rate remained roughly constant and close to zero. But when the policy rate started to increase around 2016/17, the long-term rates stayed put. By contrast, the 10-year yield increased together with the Fed Funds Rate in 2022 when the Fed began its current monetary tightening cycle.

Does this mean that the long-term and short-term rates will fall together if the Fed eases it cycle of rising interest rates? With all the discussions surrounding the fiscal imbalances in the US and the recent turmoil in the United Kingdom’s bond markets, this is far from clear. If it doesn’t happen, countries in the region may choose to issue debt of shorter maturities, exploring the lower short-term rates, but at the cost of exposing themselves to rollover risks.

Figure 1a: US Policy Rate and 10-Year Yield on US Treasury Note

Figure 1b: US Policy Rate and EMBI Latam Spreads

The Risks of Debt Crises

Now, even if the benchmark rates fall, there are implications for the spreads to consider. Figure 1b shows an average of bond spreads for a group of Latin American and Caribbean countries, the EMBI LATAM, together with the US policy rate. Peaks in the EMBI LATAM spread, associated with debt crises, do not always coincide with the peaks in the US policy rates. In fact, there have been situations where spreads have peaked during periods of reduction in the US policy rate and in periods in which the policy rate was at record low levels. This pattern suggests that other factors such as world economic growth, commodity prices, self-fulfilling crises, and domestic economic and fiscal conditions, are more important in pushing countries into debt crises. The literature on quantitative sovereign default show something similar: Shocks to the world interest rate have played a secondary role as a source of default episodes in recent decades.

US benchmark rates may begin to fall again, bringing lower costs for debt issuance for countries in our region. But it is not the whole story: Serious debt problems can emerge from other sources, and countries need to proceed with caution.