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Rate-rise timing: Federal Reserve chair Janet Yellen checks her watch |
After a dovish statement from the Federal Open Market Committee (FOMC) this week, there is a disconnect between economists’ views that September is the likely start of the US monetary tightening cycle versus traders who are punting on a delay.
However, irrespective of the question surrounding a September lift-off in US interest rates, the jury is out on how China’s economic volatility will influence the Fed’s tightening course in the coming years.
Jorge Mariscal, emerging markets chief investment officer at UBS Wealth Management, thinks the People’s Bank of China would need to follow up with more devaluations before the Fed would become concerned about the prospects for global disinflation and market volatility – though the Chinese central bank has indicated it will not kick-off a devaluation spiral.
“A 3% yuan depreciation is unlikely to be sufficiently large to change the Fed’s math,” says Mariscal. “A much larger one, say 10% to 20%, might, as it would mean China, the world’s second largest economy, is much weaker than expected.”
Aroop Chatterjee, FX strategist at Barclays, says: “A 2% to 3% devaluation of the renminbi will have no material impact on competitiveness.
“We believe the renminbi was overvalued because of its peg to a rising dollar, so the devaluation, coupled with our expectation for weaker Chinese growth in the medium term, leaves plenty more room for renminbi depreciation before it will become a problem.”
Even if the Fed were concerned about the increased competition from a weaker renminbi, those fears might be offset by more positive developments elsewhere.
“The recoveries in Europe and Japan are no doubt key positive dynamics to watch,” says Mariscal at UBS. “The two combined more than make up for the slowing Chinese economy.”
A prolonged round of competitive |
It all adds up to a high conviction among observers that the Fed remains committed to action on raising rates.
The minutes from the last FOMC meeting convinced many analysts that the decision to raise rates in September has already been taken, and that it would take something truly seismic, such as a double digit fall in the S&P, to change its mind now.
William Lee, head of North America economics at Citi Research, says: “The only thing that will stop the Fed from moving on rates now is a bunker buster that destroyed the entire mosaic of US data that depicts an economy growing at 2.5% to 4%, with inflation rising to 2% after 2017.”
Lee uses this metaphor advisedly. “It is a mosaic because there are so many different pieces of data reaffirming this picture and that it is time for the Fed to act,” he says. “Bad data that dislodges a piece or two out of this mosaic won’t be enough.”
A game-changer for the Fed would have to be an event of systemic and global significance, says Lee – something that would trigger disorderly markets, meaning a free fall in asset prices.
“A bit of volatility is easy to hedge with Vix options – that is no problem,” he says. “What would be a problem would be markets in free fall, where everyone is on the same side of the trade, like with Long-Term Capital Management or the Asia crisis in the 90s.”
Such a reaction looks unlikely, given the relatively muted response of equity markets to the news of the devaluation. The S&P 500 has traded in a tight 80 point range since February and the news from China did not cause it to break out of this range.
Lee says the FOMC will also be mindful of how markets would perceive a delay to its first, and keenly awaited, rate hike.
“If the FOMC decided to wait until October or even December and then move, [Fed chair Janet] Yellen would be asked what she had learned since September that had changed her mind, and that is a question she can’t answer,” he says.
“If she focuses on one piece of data the market will in future focus all its attention on that data, it will destroy all the careful work the Fed has done on forward guidance.”
Further reading |
However, while the FOMC is unlikely to be deterred by events in China in the short term, in the longer term, events in China might prove more influential. While US rates are unlikely to be influenced by China’s currency directly, both are driven to some extent by the same factors: global growth and risk sentiment.
Petr Krpata, FX strategist at ING, says: “The main way that China’s devaluation could influence the Fed’s decision to raise rates is if it triggers a global risk-off environment, equity prices fall meaningfully, which in turn affects US consumer confidence.”
With the Fed offering so much forward guidance as to its intentions, there is little for analysts to debate in the near term – what disagreement there is concerns finer details – but what the Fed is likely to do next year, or in 2017, is far less certain.
Krpata expects the Fed to hike rates in September, but ING has revised its forecast for 2016, now predicting the Fed will only hike rates twice in 2016, down from three before China’s devaluation.
Lee says: “The path of normalization, rather than timing of lift-off, would be much more dependent on the economic and market impact of developments we saw in China. Asia represents around 25% of US trade, so if there is a slowdown in Asia we might see a more gradual path of increases, say 50 basis point rise in rates in 2016, rather than the 75bp rise we expect.
“For now, we expect the path of normalization to be very gradual, one increase in September, the next one in January, ending 2016 at 1.25% and ending 2017 at 1.75%.”
Philip Uglow, chief economist at MNI Indicators, says: “The Fed will move slowly, but we think it might go faster than some are expecting – we may even see two quarter-point rises this year, for example. It has to be forward looking and it doesn’t want to move too late.”
The path of US rates depends on the US economy, which is influenced, to some extent, by global events. The US economy is relatively closed and is less dependent on global trade than other big economies, making it relatively well-insulated. Consequently, the US economy has historically shown a low sensitivity to CNY moves.
Typically, the FOMC is more concerned about domestic factors such as inflation, employment and retail sales, in determining interest rate policy. Here the news has been good. Unemployment is falling and wages are increasing, which will increase inflationary pressure, helping the Fed meet its target.
However, these inflationary pressures could be overwhelmed by external disinflationary pressures, such as low commodity prices and, of course, a possible slow down in Asia. And this is where the impact from China might be most significant.
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There is plenty of evidence suggesting China is slowing.
Paresh Upadhyaya, director of currency strategy for the US at Pioneer Investments, says: “Chinese official statistics put growth at around 7%, but some observers think it is closer to 5% and I agree.
“This will help China rebalance its economy and boost domestic consumption, which in China is around 38% of the economy, compared to the G10 average which is closer to 66%.”
And this, of course, has a big impact on commodities. China accounts for around 45% of copper demand, and Upadhyaya notes that if its demand for copper declined by 1%, that would create a global surplus of around 500kt.
“And 1% is not a big number – it could easily be more,” he says. “It is a similar situation in many other commodities. So prices look set to remain weak, along with the disinflationary pressure that brings.”
ING is a little more sanguine about China’s prospects.
Krpata says: “Events in China are likely to have an impact on its quarterly growth data. In June/July, there was the collapse of the equity market, which will have dented consumer confidence, while August is now set to be lost to uncertainty surrounding the impact of the devaluation.
“ING has downgraded its quarterly growth forecast to 6.7%, from 7%. But it should get back on track in Q4.”
However, if China does see sustained slowing, it will trade less with the US – the most direct channel for Chinese weakness to be imported to the US – dragging the price of US imports from China down and putting downward pressure on US price inflation.
The US will also be affected in other ways.
“An indirect channel is the effect of a weak yuan on other countries’ competitive devaluations and commodities,” says Mariscal. “The latter would magnify the upward pressure on the US dollar.”
He worries China’s devaluation has increased the risk of a currency war, which could lead to US dollar strength. “This in turn could mean a lower path for US rates than would otherwise be the case,” he adds.
MNI’s Uglow agrees. “A 3% or 4% devaluation is not a big deal, but the danger is if other central banks in the region want to change their monetary policy to get back to where they were relative to China, probably by cutting rates,” he says. “A prolonged round of competitive devaluations would be damaging.”
How the FOMC will interpret all these variables remains to be seen. Any disinflationary impact caused by the weaker renminbi via falling energy and food prices might be seen as a one-off event, likely to disappear from the data in future readings.
However, if these factors are felt over a prolonged period, they will be harder to ignore.
Either way, the Fed is likely to be extremely cautious as it proceeds, and Pioneer’s Upadhyaya believes even its modest longer-term interest-rate target might be too ambitious.
“The Fed has said its long-term target is to get to the 3.25% to 3.75% range, but it looks to be a tall order to get there,” he concludes. “Inflation is unlikely to be a worry any time soon and the US Treasury curve continues to flatten, showing markets are sceptical about the rates target.”