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Saturday, 19 December 2015

To fellow US interest rate hike or to cut rates?

Emerging economies in a dilemma on whether to follow suit or cut rates

“Specifically, we expect rate cuts in India, Indonesia, South Korea, Taiwan and Thailand in 2016. We also project a further 75bps of rate cuts and a 200bps reduction in RRR in China'. - Credit Suisse

THE big question is what happens next?

The much anticipated hike in US interest rates on Thursday meant that for the first time in almost a decade, US interest rates are on the way up. The 25 basis point (bps) rise in US interest rates by The Federal Open Market Committee (FOMC) to between 0.25% and 0.5% was made as the US economy showed tangible signs of improvement.

Such gains in the US economy through lower unemployment and higher forecast inflation has meant that the target for interest rates by the end of 2016 has been pegged at 1.5%, meaning that rates are expected to rise by 25 basis points every quarter until the end of next year.

The implications of what the US FOMC does reverberates throughout the world. Conventional thinking of the past is that higher rates in the US does put pressure on central banks elsewhere to follow suit.

But times have changed. Countries today have their own domestic economies and issues to manage and that has taken precedence over what the US does with its monetary policy.

It is clear that the de-coupling has taken place a long time ago. The European Union and Japan are still engaged in quantitative easing and are keeping rates near zero or in the case of the EU, in negative territory.

For Malaysia, the thinking is that with the difference between domestic and US interest rates still having a nice cushion, the focus of Bank Negara will be on the Malaysian economy.

Rate pressure: Should the path of the US rate cycle starts to steepen, economists say it will put pressure on Bank Negara as the ringgit may be pressured by inaction. – Reuters Countries such as China cut its interest rates in October to 4.35% as it grapples with a slowing economy. Different priorities call for different action.

But analysts feel the move by the US does create a bit of a dilemma for policy makers. Raising rates does cool an economy, which is already shifting to a lower gear given the tangible cooling of major economic indicators.

Trimming interest rates further, while will help the economy, will put more pressure on the flow of capital. Analysts feel that might not be what the central bank will want to do at the moment considering the weakness of the ringgit not only against the US dollar this year but also against the currencies of its major trading partners.

“Our rate is accommodative for economic growth and Bank Negara can raise rates when the economy is slowing down,” says an economist with a local brokerage.

To each its own

The United States has been the traditional locomotive of growth for the world for much of recent history. But the emergence of China has changed that equation. Trade of the emerging world increases with China as the second largest economy of the world grows, its influence on Malaysia and the rest of Asia has become more affixed.

It is for that reason that some are speculating that emerging economies, such as Malaysia, will keep its eyes focused on what the People’s Bank of China does while having the US action in its periphery vision.

“We argue that Asian central banks’ monetary policy stance next year will be more influenced by economic and monetary policy cycles in China than in the past, and will diverge from the US. Unlike the previous US Fed hiking cycle when virtually all Asian central banks tightened their policies, we think this time Asian policy rates will stay lower for longer,” says Credit Suisse in a report.

“Specifically, we expect rate cuts in India, Indonesia, South Korea, Taiwan and Thailand in 2016. We also project a further 75bps of rate cuts and a 200bps reduction in RRR in China.

“Given the challenging environment for exports, we expect growth in trade-dependent economies including Hong Kong, Malaysia, Singapore, and Thailand to surprise the consensus on the downside. Meanwhile, more domestic-oriented economies with policy catalysts, including Indonesia and the Philippines, could outperform expectations considerably,” it says.

For Malaysia, the FOMC decision was keenly watched. Any time US interest rates move, Bank Negara pays close attention to it.

Is it the key determinant for the direction of domestic interest rates?

No, say economists. “Local conditions override what the US does,” says an economist.

For Malaysia, economists believe that the current overnight policy rate of 3.25% is appropriate to support growth. But they do too acknowledge that Malaysia is in a dicey situation depending on what happens next.

The general view is that the US will continue to push rates upwards. Just how rapidly will be important and as US rates goes up, the differential with Malaysia will narrow.

“If the local economy does as it is predicted, then there is a possibility of a small hike next year but there is no urgency to do that,” says an economist.

The question is what happens after next year should the path of the US rate cycle starts to steepen?

Economists say that will put pressure on Bank Negara as the ringgit might be pressured by inaction. As it is, the drop in crude oil prices is the most pressing issue affecting the value of the ringgit.

The effect on emerging currencies

Emerging markets have had a series of bad press over the past year. With sentiment souring and the outlook in the US getting brighter, it was no coincidence that the US dollar surged, gaining about 40% on average against emerging market currencies since May 2013.

But is it time for things to change?

Schroders thinks that might happen.

“It is difficult to argue that the Fed has been the sole factor in emerging market debt weakness. China hard landing fears, plummeting commodity prices, Brazilian political disarray, Russian policy concerns and general weakening of growth across all regions created a near perfect-storm for emerging market debt investors.

“However, a more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite. If developed market bond yields remain very low – as seems likely with a very slow hiking path, set out with some confidence – emerging market dollar yields may remain one of the few places to look for meaningful income generation for years to come,” it says.

Schroders says the move by the US Federal Reserve comes at a time when emerging market dollar debt seems particularly attractive.

“Yields in the primary sovereign dollar index are at highs not seen since 2010, when Treasury yields were much higher than today. Yield spreads over Treasuries for investment grade sovereign debt are just under 300 basis points, and remain at elevated levels that were last seen consistently during the European crisis of 2011. High yield sovereign debt currently has a yield to maturity of 8.5%.

“The divergence between developed market monetary policies has driven the dollar nearly 20% higher on a trade-weighted basis since July 2014. Emerging market currencies have fallen in lock step.

“With the European Central Bank now charting a path towards a steady dose of quantitative easing as growth in Europe stabilises, Fed predictability should help curb that dollar appreciation. Emerging market currencies should then likely steady at attractive levels, boosting sentiment towards the asset class. Even a modest virtuous cycle led by these factors could make emerging markets one of the strongest global fixed income performers next year, given today’s generous yield levels.”

By Jagdev Singh Sidhu The Star/Asia News Network

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