THE emerging markets (EMs) may face a tough situation ahead, as the United States Federal Reserve (Fed) speeds up its time frame for hiking interest rates, and indicates the start of talks to scale back its massive bond buying.
Given the rapid pace of vaccination and reopening in the US and other developed markets, the divergence in the pace of vaccination between EMs and these markets may cause more volatility and turbulence in EMs.
While some question if the Fed really wants to get hawkish, EMs still have to prepare for the worst-case scenario that they will go ahead.
EMs that are still struggling with Covid-19 infections, slow pace of vaccinations and growth, may see a reversal of capital as funds leave for higher interest rates and returns in developed economies.
Many governments and companies in EMs, with high foreign currency debts, may be further burdened with higher interest payments and hence, increased financing costs.
Currently, the Fed buys bonds and other securities to increase the supply of money, thus lowering rates and helping to stimulate the economy.
When it withdraws from buying bonds, rates will rise; apart from that, inflationary pressure from its recovering economy will also cause the Fed to raise rates later.
The Fed had been downplaying the risks of rising inflation in the US, which is possibly due to the low base effect and supply chain bottlenecks. But it caught the markets by surprise when the Federal Open Market Committee signalled last week that rates could rise in 2023, unlike in March when it saw no increases until after that.
In the near term, the Fed may not be in a hurry to shift from its low interest rate policy; against lofty expectations, the recent jobs numbers were disappointing – non-farm payrolls in May may have jumped to 559,000 but it is still below estimates of 671,000.
Market consensus is that it may start tapering this summer and start reducing its bond purchases before the end of the year. “If that happens, rising yields will shatter the appeal of EMs and undermine their currencies, bonds and shares,’’ said Socio Economic Research Centre executive director Lee Heng Guie.
EMs are currently flush with liquidity; while US rate hikes will affect sentiment and liquidity, they could be less sensitive to this due to their own positive growth, said Areca Capital CEO Danny Wong
Despite the Fed saying it will raise rates in 2023, there is a possibility of it doing so in the second half, or first half of 2022. This will have a detrimental effect on EMs that are slower in their vaccination rollouts, as it will crimp their source of cheaper funding, said Etiqa Insurance & Takaful Bhd chief strategy officer Chris Eng.
While most of the inflationary pressure is from the supply side and temporary, demand-driven inflation will probably rise sharply over the next few months.
“So by year end, the Fed should seriously think about that aspect,’’ said Eng. “Opinions of the Fed officials will evolve, and they should control inflation sooner than later.’’
If inflationary pressure persists into 2022, the Fed may raise rates earlier than 2023, a tightening by the Fed, coupled with the fading effect of the earlier government stimulus spending, will likely result in more moderate growth in the US, said former RHB Research Institute chief Asean economist Peck Boon Soon. The other central banks in developed economies are likely to follow suit but with some time lag, leading to some slowdown in growth.
Elsewhere, the Bank of England and Bank of Canada have slowed their bond buying programmes; Norway’s central bank has has brought forward the possibility of rate increases and New Zealand’s central bank is speculated to raise rates by May 2022, earlier than previously thought.
Predicting that US rate increases could begin next year, St Louis Fed president James Bullard said that he was among the seven officials with that expectation.
The Fed funds rate is at a low of 0.25% but with expected rate hikes in 2023, it could hit 0.6% by the end of 2023, from the previous survey of 0.1%. The Fed raised its gross domestic product forecast for 2021 from 6.5% to 7.0%, with inflation likely to rise from 2.4% in its March estimates to 3.4%.
Consumer prices in May rose at their fastest pace in almost 13 years; the core inflation rate, which excludes food and energy prices, jumped 3.8%, representing the sharpest increase in almost three decades.
While the US economy is still affected by Covid-19, there are signs that activities and employment have picked up. In the US labour market, non-farm payrolls in May accelerated to 550,000 (although below expectations for 671,000) from 278,000 in April. This was accompanied by a persistent decline in the US unemployment rate from 14.8% in April to 5.8% in May, and increase in the average hourly earnings to 2% in May from 0.4% in March.
“So, we can expect the US dollar to rise, leading to the weakening of EM currencies in the immediate term,’’ said Bank Islam Malaysia chief economist Afzanizam Abdul Rashid.
The US dollar index, which measures it against a basket of six major currencies, was on fire last Thursday following this unexpected shift in the Fed’s inflation and rates outlook, rising 0.9% to 91.94.
For now, there is limited impact; reducing its purchases of US$120bil (RM497bil) worth of bonds monthly means that the US is still buying bonds and pumping liquidity into the financial system.
By the later part of next year, if the Fed stops buying bonds and lets its portfolio mature, there might be some impact like a small foreign outflow from ringgit assets in equities and bonds, said Hong Leong Bank managing director of global markets, Hor Kwok Wai.
The timing of events in EMs and developed markets is crucial this time. Previously, any rate cut by central banks here was largely done in tandem with similar cuts by their counterparts in developed countries. But this time, any rate cuts here would be made at a time when the “big guys” are thinking of withdrawing stimulus, or raising rates.
“If all these hawkish actions by the developed economies come to bear when vaccinations here have picked up to much better levels, the divergence will be less painful,’’ said OCBC Bank Malaysia Bhd economist Weillian Wiranto. The actual resolve of the Fed is left to be seen.
The long timeline is best read as an indication that it is giving itself plenty of opportunities to change its mind before 2023, said former Inter-Pacific Securities head of research Pong Teng Siew. “My bet is that the Fed will turn tail at the first signs of any slowing; it wants to appear hawkish without any intention of actually moving towards a rate hike,’’ said Pong.
Under whichever scenario, let us hope that we can catch up with the pace of vaccinations, and keep a tight control on Covid-19 infections so that we can get on with economic revival and not be left too far behind.
Yap Leng Kuen is a former StarBiz editor. The views expressed here are the writer’s own.