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Will the world choke on rising interest rates? A modest move up in borrowing costs is already rattling global markets and causing some observers to worry about what lies ahead for the mighty U.S. economy.

To date, the biggest casualties have been emerging-market countries with large amounts of U.S. dollar loans. As rising U.S. rates have propelled the greenback higher in recent months, the loans have become more expensive to service in terms of local currencies. At least a couple of developing countries are struggling to keep up.

All of this is eerily reminiscent of the 1997 emerging-markets crisis, when money stampeded out of developing countries, leading to a chain reaction of defaults and near defaults that threatened the global economy.

“Are we gonna party like it’s 1997?” Paul Krugman, the Nobel-winning economist, asked in a tweet this week. “Stuff is happening in emerging markets with at least a whiff of an old-style currency/financial crisis.”

Prof. Krugman worries that both the United States and Europe are in a worse position to respond to any emergency than they were two decades ago. Central banks typically cushion shocks by cutting borrowing costs, but in today’s low-rate environment, there’s simply not much to cut.

On a more positive note, most developing countries – with the notable exceptions of Turkey and Argentina – are in better shape than they were two decades ago. A rising U.S. dollar doesn’t have to pose the same threat to many of those countries as it once might have.

“So are we seeing the start of another financial crisis?” Prof. Krugman asks. “Probably not – but I’ve been saying that there was no hint of such a crisis on the horizon, and I can’t say that anymore. Something slightly scary this way comes.”

Exactly how scary depends, for now, on how exposed you are to emerging markets. The MSCI Emerging Markets Index has lost ground in recent weeks. Most developing-country currencies have slid versus the U.S. dollar. Argentina has run to the International Monetary Fund for aid in supporting the plunging peso, while Turkey has boosted interest rates to punishing levels to support the lira.

Most likely, the recent turbulence will turn out to be a tempest in a teacup. “Warnings that the market turmoil in [emerging markets] could presage a spate of crises similar to the late 1990s look overdone,” says Neil Shearing of Capital Economics. He doesn’t see problems across the developing world outside of Turkey and Argentina. Most emerging economies don’t have the same levels of U.S.-dollar debt they did back in 1997, so they’re not as exposed to rising U.S. rates, he says. Indeed, he expects growth to start picking up in Russia, Mexico and Brazil.

But there is no guarantee of that, especially if a booming U.S. economy drives rates higher than people expect. The widening gap between what money would earn in the U.S. versus what it would earn elsewhere would draw cash into the United States, creating a nasty feedback loop in which money would flow out of emerging markets and into an economy already operating near full capacity.

It’s a scenario that stems from Washington’s decidedly unusual approach to economic management. Most observers believe the United States is in the late stages of the economic recovery that began after the financial crisis a decade ago. With unemployment at its lowest level since 2000, there’s no obvious need for more financial stimulus.

Yet the Trump administration, in collaboration with a Republican Congress, has insisted on pumping more and more fuel into the economic engine. Massive tax cuts are turning up the heat on an already hot economy. To keep inflationary pressures in check, the Federal Reserve has hiked borrowing costs, opening up the gap between U.S. yields and those in other countries.

The danger is that the U.S. rates could surge far past current expectations of what is reasonable. Mark Schofield of Citigroup Global Markets wrote in a note this week that it’s hard to see how the yield on the benchmark 10-year U.S. Treasury can stay near its current level of around 3 per cent if current levels of growth persist. To stay consistent with those fundamentals, the 10-year yield would have to jump to between 4 per cent and 4.5 per cent – a huge shock in bond-market terms.

Most people believe such a jump is impossible and Mr. Schofield acknowledges it’s not the most likely outcome. Still, he says people caught up in the current exuberance are unjustly ignoring the possibility of such a dramatic move. “The current narrative seems heavily loaded in favour of yields remaining low rather than the possibility that they move significantly higher,” he said.

He’s not the only person to be concerned about the risks building up in an overheated U.S. economy. “Trumponomics will cause the next recession within the next 12 months,” David Rosenberg, chief economist at Gluskin Sheff + Associates Inc., said this week. Washington’s insistence on running large deficits at a time of full employment runs contrary to every rule of good economic management, he says, noting that it’s “akin to giving steroids to a musclebound wrestler.”

In his view, the inevitable result of current policy will be rising inflation, which the Fed will respond to by raising borrowing costs. Not only will emerging markets be hit by those rising rates, but so will the U.S. housing market. Rising mortgage rates already appear to be dragging down mortgage applications for new home purchases, while housing starts have also disappointed.

“Housing is the quintessential leading indicator of the economy, and the action beneath the veneer of the major equity indexes is flashing a warning sign on this expansion – the second-longest ever at 107 months,” Mr. Rosenberg says.

The Citigroup Economic Surprise Index, a measure of how economic readings compare to forecasts, indicates that U.S. data has fallen short of expectations since the start of the year. Most observers still believe the Fed has the power to offset any economic weakness by chopping rates. But the recent turbulence is a reminder that the path back to precrisis normalcy could be bumpier than we ever expected.

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