Throughout February, Fed officials increasingly signaled the probability of a rate hike at the March Federal Open Market Committee (FOMC) meeting, scheduled for March 14-15. During her semi-annual congressional testimony, Fed Chair Janet Yellen warned that it would be “unwise” to raise rates too slowly and characterized the economy as one with sustained growth, rising inflation, and robust labor markets. William Dudley, head of the New York Federal Reserve, also stated that a rate hike had become “a lot more compelling”, and Lael Brainard, a Fed Governor known to be dovish, suggested that a rate hike would be appropriate “soon”. Minutes from the Fed’s January meeting revealed that many policymakers considered rate hikes to be appropriate fairly soon, despite uncertainty surrounding the Trump administration’s spending and tax polies.
Recent economic data demonstrate gains in inflation and employment
In January, personal consumption expenditure (PCE) inflation grew 1.89% year-over-year (YOY) compared to 1.10% YOY in January 2016. Core PCE inflation, which excludes food and energy prices, grew 1.74% YOY in January, compared to 1.61% YOY in January 2016. Although inflation has increased modestly over the past year, survey-based measures of longer-run inflation expectations have remained stable around 2%. Non-farm payrolls increased by 227,000 in January and the unemployment rate was steady around 4.8%. The Fed’s most recent Beige Book, which reports current economic conditions based on qualitative surveys in each of the twelve Federal Reserve districts, highlighted tight labor markets, with some districts facing labor shortages. Although recent economic data demonstrate gains in inflation and employment, Fed officials will be looking to the US Bureau of Labor Statistics March 10th release of its February employment report.
Markets have rapidly priced in a March rate hike. The futures-implied probability of a March hike rose from 32% at the beginning of February to 100% by March 8.
Rate hike could have muted impact on emerging markets
Should a rate hike materialize in March, it is likely to be consistent with past increases of only 25 basis points. An increase of the Federal Funds Rate (FFR) target to 0.75%-1% will drive a short term strengthening of the dollar against most emerging market currencies. However, capital outflow in emerging markets will be mitigated by negative interest rates in the Eurozone and Japan, and the responses of emerging market central banks to the FFR hike.
- Positive spreads between emerging market and Euro area or Japanese bond yields will support continued capital inflow to emerging markets: Although emerging market currencies may weaken slightly against the dollar, there’s a good chance they will stay strong relative to the Euro or the Yen as long as extremely low interest rates in these regions persist. European and Japanese yields are likely to remain low given continued quantitative easing. The Bank of Japan continued its policy of quantitative easing at its January meeting and recently released schedules of planned asset purchases, reaffirming its commitment to keeping interest rates near zero. Although economic conditions have begun to improve in the Euro area, markets still consider a ECB rate hike to be at least a year out. Flight to safety into German and “core” Eurozone debt in response to fears over a Le Pen presidential victory in France, has suppressed Eurozone yields and driven the German 2-year yield to record lows
- Emerging market central banks can respond to a FFR hike: Central banks can respond to depreciation pressure by drawing down foreign currency reserves. Many emerging markets have built up their foreign currency reserves since the financial crisis, suggesting that they will be able to moderate exchange rate volatility. Although foreign currency reserves in China, Venezuela, and Nigeria have fallen precipitously over the last few years, many emerging market central banks still have substantial reserves. Some countries will also respond by increasing their own interest rates, a move that would further dampen capital outflow
Managing a Stronger Dollar
To prepare for a strengthening dollar, multinationals should consider the following:
- Assess exposure to dollar assets and liabilities. Companies backed by a currency that depreciates relative to the dollar will gain on their dollar-based assets, but lose on their dollar-based liabilities
- Prioritize export markets that can take advantage of a real dollar appreciation
- Prioritize countries that can contain exchange rate volatility through modest increases in interest rates and reasonable intervention in foreign exchange markets