Wow, what a volatile week in the markets! Black Monday 2015 kicked off violent moves in stocks and currencies. Stock markets managed to recover all of its losses and even finished the week higher in some cases. Unfortunately, that can’t be said about the currency markets as the yen and the USD outperformed the rest of the field as panic caused wild swings in currencies. The Americans pointed the figure at the Chinese for the cause of the sell off – the Chinese government failed attempt to support their equity markets followed by an unexpected devaluation of their currency. The Chinese retort was that stocks have moved sideways since the US Fed stopped QE in November and that the speculation around the Fed’s next move finally hit caused a panic. Who’s right? We happen to think that both sides are correct. Volatility always occurs at the end of a trend and the beginning of a new one. Market participants are nervous because of the two powerful and opposing threats to growth and stability – the risk of a deflationary slump if China buckles and the emerging market crisis turns systemic; versus the risk that central banks could fall behind the curve and leave too much stimulus in their own economies.
We think that most of you are by now familiar with the market turbulence caused by the threat of an interest rate hike by the U.S. Federal Reserve. The prospect of the Fed’s first rate hike since 2006 has fuelled growing fear of renewed volatility in emerging economies’ currency, bond, and stock markets. The concern is that rising interest rates will lead to a rising USD which will wreak havoc among emerging markets’ governments, financial institutions, corporations, and even households because they all have borrowed trillions of USDs and rising interest rates and a rising USD will cause debt servicing costs to rise.
Now imagine the pressure on currencies of oil producing countries. Most of these countries peg their local currency to the USD and plummeting oil prices are straining government budgets. Earlier this month, Kazakhstan decided to give up its peg and switched to a free float. This move caused Kazakhstan’s tenge to plunge a record 23% in one day, but it freed it from burning through its reserves in order to prop up its currency. Kazakhstan’s Prime Minister Karim Massimov told Bloomberg that in the new era of low oil prices “most of the oil-producing countries will go into the free-floating regime, including Saudi Arabia and the United Arab Emirates.” Indeed, expectations have grown after Fitch cut Saudi Arabia’s outlook to negative from stable last Friday. Fitch noted that the twin fiscal shocks of lower oil prices and increased spending under new Saudi King Salman bin Abdulaziz al-Saud will cause the budget deficit to widen to 14.4% of GDP this year. The budget is sure to rise on news that Saudi Arabia invaded Yemen on Friday.
With government budgets of emerging markets and oil producers under stress, these countries have had to rely on the selling of their reserves mainly by way of selling US Treasury’s. Speaking of selling Treasury’s, according to Societé Generale SA, the central bank of China has likely sold somewhere on the order of $100 billion in US Treasury’s in the past two weeks alone in open FX operations in order to slow down the fall of the yuan after it devalued its currency earlier in the month.
On the surface, this seems harmless. But in reality, it is a major headache for the USD and the U.S. with multiple ramifications. First, if these countries are selling US Treasury’s then they are not buying. This begs the question of who will step in to fund U.S. deficits? Second, the selling alone could cause yields to increase. If yields break above the trend line on the chart of 10-Year US Treasury yield it would signal that major central bank selling is overwhelming the buyers. This would cause the Fed to ease. Ironic isn’t it? A Fed rate hike would increase the stress on emerging market and oil producing countries, which in turn would cause them to tap their reserves by selling US Treasury’s, causing bond yields to rise and triggering a monetary policy reversal by the Fed, possibly in the form of QE4.
We Are Asking Too Much of the Federal Reserve
A well written article is making the rounds in the blogosphere of financial and political pages alike by Robert Kuttner who is co-founder and co-editor of ‘The American Prospect'. It’s worth a read and re-printed below.
There has been obsessive chatter about whether the Federal Reserve will, or should, raise interest rates this fall. At the Fed's annual end-of-summer gabfest at Jackson Hole, Wyoming, the issue was topic A. Advocates of a rate hike make the following claims:
Very low rates were necessary when the economy was deep in recession. Now, with growth up and unemployment down, the near-zero rates are creating speculative bubbles. They are not really stimulating the economy much, as corporations put cash into stock buybacks and bankers park spare money at the Fed itself. So, let's get on with a more normal borrowing rate.
Opponents of a rate hike counter that the economy is a lot weaker than it looks. Wages are going nowhere. A lot of the jobs that have pushed down the nominal employment rate are lousy jobs. China's economy has just hit a big wall, which will slow down global growth.
Raising rates will increase consumer and business costs across the economy – everything from home mortgages to credit cards to construction loans. There will come a time to raise rates, but we are not there yet. If anything, the Fed should find new ways to get money out into the real economy.
The Fed is famous for raising rates prematurely, seeing ghosts of inflation. But there is no inflation on the horizon -- the bigger worry is deflation. In fact, the inflation rate is well below the Fed's own target of two percent. And the Fed is the only game in town. On balance, I think the opponents of a rate hike have the better argument. But consider for a moment that last assumption -- that the Fed is the only game in town.
The larger issue, which is getting submerged in the great debate about raising rates, is that the Fed should not be the only game in town.
Normally, in a soft economy, the government would be using fiscal as well as monetary policy. But because of the obsession with deficit reduction -- unfortunately shared by the Obama Administration (remember the Bowles-Simpson Commission?) – fiscal stimulus today is off the table; worse, deficit-reduction is contractionary. In plain English, prolonged deficit-cutting slows down growth.
