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Lessons from the FED’s interest rate normalisation: What we have learned, and what we have yet to figure out
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Lessons from the FED’s interest rate normalisation: What we have learned, and what we have yet to figure out

Moritz Sterzinger Weekly bulletin October 2018
Blink and you’ll miss it. Last week the Federal Reserve hiked interest rates by another 25bps, raising the upper bound to 2.25%.

It seemed like just another day at the office since markets were expecting the increase, just as they’re expecting another 25bps step-up in December. At this point the funds rate will be approaching the magic “3%-longer-term-FED-dot-plot-projection”, where LIBOR markets are expecting it to stay for the long term.

With the outlook ahead relatively clear, let’s take stock of what the current hiking cycle has revealed – and what still remains to be seen.

Interest rates influence currency markets, but only so much

Remember the call for EUR-USD to go to parity or USD-JPY to hit 200? One of the main justifications was that higher interest rates would attract people to shift their assets into USD away from lower-yielding currencies, such as the EUR and the Yen. Valid though this argument is, it ignores that at the end of the day the real economy is an equally strong, if not even more important driver of exchange rates. If you are an export powerhouse with notable trade surpluses, such as the Eurozone or Japan, then the natural demand for your products will prevent your currency from sliding beyond a certain point. Countries that run trade deficits and depend on foreign direct investments are much more prone to capital flight than export-oriented economies.

Emerging markets are more resilient than you think

A formerly popular line of thinking went as follows: the Fed starts hiking rates, investors sell their commodity investments, commodity prices drop. In combination with a stronger USD (due to higher real rates), this was to wreak havoc among resource-dependent, USD-debt-laden emerging economies. Admittedly, things did get a little rough for emerging market equities at the start of 2016. But financial carnage as seen in 1997, didn’t follow. Yes, there are causes for concern, such as Argentina, Venezuela and Turkey, but this has more to do with domestic economic policies than with a general rush out of emerging market investments. The promised emerging market meltdown has failed to materialise.

It is easy to underestimate the pace of rate hikes

I recently looked at a USD swap trade from autumn 2016 that expires in 2019. The rate locked in at the time was 1.12%, which compares to a current market rate of 2.7% – so the instrument is deeply in the money. We now know that markets significantly underestimated the pace (and determination) with which the Fed would increase interest rates when it embarked on its path to a “normal” environment. It is a lesson that bears repeating for other economies: one shouldn’t be too complacent about interest rate risk despite good arguments for why rates might stay lower for longer.

A decade of monetary policy experimentation and a lot of wrong calls

Some worried about hyperinflation when interest rates were near zero. Others fretted that the Fed hiking interest rates would plunge the US and the world economy into a recession. Others wondered whether Keynes was right after all, with his comment about monetary policy becoming “like pushing on a string”. There is a lot of talk about the Phillips Curve informing the Fed’s policy, yet recent years have been a testimony to its questionable foundation: inflation remains low despite low unemployment.

There are still many questions to be answered on the efficacy of monetary policy, its effects on financial stability, and the true, underlying causes of inflation.

Economists and financial commentators may come up with answers. They will most likely be wrong.

For more information, please contact Moritz Sterzinger, Associate Director at JCRA, at Moritz.sterzinger@jcrauk.com.

 

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