June 29, 2017 – This post was written by Cailey Stevens, Senior Analyst, and Josh Ashkinaze, Research Intern
At their June meeting the Federal Reserve (Fed) raised the target for the Federal Funds Rate (FFR) to 1-1.25% and announced plans to begin gradual balance sheet normalization by year end provided that the economy evolves in line with expectations. The Fed also announced a specific plan for shrinking its securities holdings by tapering reinvestment rather than selling holdings directly. This post will explore the impact of tighter US monetary conditions on emerging markets and offer strategies for adapting to this environment.
Interest Rate Hike
On June 14, 2017, the Fed raised the target FFR by 25 basis points to 1-1.25%, in line with market expectations. Federal Open Market Committee (FOMC) Member’s outlook on the economy and the pace of rate hikes was essentially unchanged from their March outlook, with the majority of participants expecting one more rate hike in 2017, in line with FrontierView’s view. During her press conference, Janet Yellen emphasized the importance of not overreacting to low inflation numbers and highlighted a tight labor market as evidence of a strengthening economy.
Balance Sheet Normalization
The Fed also announced that it will start balance sheet normalization, by gradually reducing its securities holdings. The process is likely to start by the end of the year if the economy evolves in line with the Fed’s expectations. Fed officials expect continued improvement in labor market conditions and economic growth, along with an inflation rate—excluding food and energy prices—that moves back towards 1.7% by the end of 2017.
Instead of selling its holdings directly, the Fed will smoothly reduce its reinvestment in securities through a cap or threshold-like mechanism. Currently the Fed reinvests principal payments from its securities holdings in new securities. Under the cap mechanism, principal payments will only be reinvested in new securities after a specific amount of principal has been collected each month. For treasuries, the cap will start at $6 billion a month and increase to $30 billion a month over the course of a year. For agency debt and mortgage-backed securities, the cap will start at $4 billion a month and increase to $20 billion a month over the course of year. The gradually rising caps will slowly reduce the size of the Fed’s balance sheet by lowering the amount of principal that gets reinvested in new securities each month. After hitting their respective maximums, the caps will stay in place until the Fed decides it has a sufficient amount of reserves to effectively conduct monetary policy. The Fed expects to determine the optimal level of reserves over the course of normalization but stated that it is likely that reserves will be lower than the past few years, but higher than they were before the financial crisis. Although it will be gradual, balance sheet normalization will lead to tighter monetary conditions in the short and medium term.
Implications for Emerging Markets
- Dollar appreciation: The June FFR hike was largely expected by markets, and did not send the dollar markedly higher. If US economic growth underperforms relative to market expectations, market participants will price in a potential delay of balance sheet normalization or a new interest rate hike, and the dollar will depreciate. If, however, economic growth outperforms market expectations, market participants will price in a sooner start date for balance sheet normalization and a new interest rate hike, causing the dollar to appreciate. In FrontierView’s view, dollar appreciation will be faster than expected if Congress moves quickly to implement tax cuts in Q3 or passes an infrastructure spending program before 2018
- Capital outflow will be mitigated by low interest rates in developed markets: Although higher interest rates in the US will engender capital outflow from emerging markets, low interest rates in other developed markets will support capital inflow into emerging markets as investors search for yield. The European Central Bank and the Bank of Japan have maintained interest rates of zero percent and -0.1%, respectively, while the Bank of England (BoE) maintained its policy rate at 0.25% after its June meeting
- Higher US interest rates will impact emerging markets differently: Emerging markets with lower public debt, tighter capital controls, and higher foreign exchange reserves generally experience less volatile capital flows
- Emerging market central banks can respond to a FFR hike: Central banks can respond to depreciation pressure by drawing down foreign currency reserves. Countries like China, Chile, and Argentina actively use their foreign currency reserves to moderate exchange rate volatility. Central banks can also respond by increasing their own interest rates which further dampens capital outflow. For example, the Mexican central bank has responded to recent US monetary tightening by increasing its policy rate
- Counterbalancing factors: While higher US interest rates play a role in the value of foreign currencies, this valuation is also influenced by domestic factors. For example, the Euro has strengthened against the dollar due to positive political outcomes in the Eurozone (i.e. Macon’s election in France) despite recent monetary tightening in the US. It is important to evaluate the extent to which international and domestic factors balance out in any given market
Managing a stronger dollar
Although the dollar is likely to strengthen only modestly throughout 2017 and 2018, multinationals should be prepared to deal with a strengthening dollar. Actions to consider include:
- Assess exposure to sovereign governments with large stocks of US dollar denominated debt: In countries with currencies that weaken against the dollar, dollar denominated debt is harder to pay back since it takes more units of local currency to repay one dollar. Governments that are faced with these higher debt servicing costs will have less money for public expenditures and investment. In countries that respond to exchange rate volatility by drawing down their foreign currency reserves or increasing their interest rates, governments will face less pressure from rising debt servicing costs
- Assess exposure to import costs: Countries with currencies that depreciate against the dollar will face rising import costs. Companies that sell imported products or use them as intermediate goods in these markets will face a tradeoff between expanding market share at the price of profitability (by absorbing rising import costs) and protecting profitability at the expensive of market share (by passing rising import costs onto consumers). Locally produced consumer goods, however, will gain a price advantage over imported products
- Asses consumer price sensitivity: In countries with currencies that weaken against the dollar, consumers with dollar denominated debt may scale back purchases as their disposable income falls. MNCs can retain these customers by extending credit to customers, or by making products more affordable through smaller packaging or lower cost options
- Focus on countries that will benefit from a dollar appreciation: Countries that rely on US tourism such as the Caribbean could see increased demand as Americans or dollar-funded tourists take advantage of a strong dollar
- Focus on industries that will benefit from a dollar appreciation: Companies that are backed by a currency that depreciates against the dollar will see their margins improve if they have dollar-denominated revenues (such as commodities exporters). This is because the amount of local currency they receive per one dollar increases as the dollar appreciates