With another Fed funds rate announcement due, today, 28 October, market uncertainty in anticipation of a rates hike "lift-off" is rising. Today's GEO looks at the implications of a rates increase for the US dollar and the dynamics the Fed's indecision to commit to a…
With another Fed funds rate announcement due, today, 28 October, market uncertainty in anticipation of a rates hike “lift-off” is rising. Today’s GEO looks at the implications of a rates increase for the US dollar and the dynamics the Fed’s indecision to commit to a “lift-off” date.
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Mon 26 October
New Zealand Trade Balance (actual:-1222M expected:-822M previous:-1079M)
Tue 27 October
UK Prelim GDP (actual:0.5% expected:0.6% previous:0.7%)
US Consumer Confidence (actual:97.6 expected:102.5 previous:102.6)
Wed 28 October
Australia CPI q/q (actual:0.5% expected:0.7% previous:0.7%)
Fed Funds Rate
Thu 29 October
US Unemployment Claims (expected:264K previous:259K)
Fri 30 October
Bank of Japan Monetary Policy Statement
Canada GDP m/m (expected:0.1% previous:0.3%)
The uncertainty being created by the Fed’s delay in announcing the inevitable rates hike is causing market behavior to become cautious. We examine the effects on markets and the US dollar going forward.
The first thing to understand about global finance during the past 7 years is the dynamic of money flow that was initiated by the Fed’s zero interest rate policy (ZIRP) and quantitative easing (QE) programs introduced after the 2008 credit crisis.
QE, or “money printing” by the Fed had the effect of devaluing the US dollar because as money supply is inflated each unit of currency is worth less and less as the pool of money in circulation grows. So, investors do not want to hold US dollars while the currency is being actively devalued, and many chose to convert the dollars to stable foreign currencies, to gold, and to stocks.
ZIRP means that holding currency in a bank deposit or even a money market account yields zero percent growth. The net effect of depositing US dollars in a US bank account during the 2008 to 2014 period would have been a loss on those dollar funds as they were being devalued (by QE) faster than the near-zero interest rate (<0.25%) could yield growth.
The popular strategy of large institutional investors and shadow banks was to create mutual funds that invested US dollars in Emerging Market stocks and commodities.
The value of the dollars was, therefore, transferred to developing nation stocks and commodities and the process spurred developing nation economic growth which, in a feedback cycle, generated generous yield for foreign investors.
Inevitably, the Fed “tapered” QE and finally halted the QE program at the end of 2013. With the US dollar no longer being actively devalued investors were able to take profit on their emerging market investments, converting the value back to USD and repatriating their dollars.
The effect was an outflow of investment from the developing economies and an inflow of US dollars to the US economy, thereby strengthening the currency. This is the “money flow” in action.
As a result of money flowing back into the US economy, during 2014, the value of the USD surged while developing nation economies suffered the consequences of disinvestment.
The dynamic became headline news in mid-2015 when slowing growth in China prompted US investment funds to take handsome profits on their China-based investments, sending the Shanghai Composite Index plummeting and leaving domestics investors holding the empty bag.
Ordinary working Chinese people thought their stock market advance was fueled by China growth. Of course, it was to some extent, but when the growth faltered (as it always does, and when you least expect it) it became evident who the largest buyers were and that money flow, initiated by Fed QE and ZIRP, had been blowing the stock market bubble all along.
With the proposal of an interest rate increase from near-zero coming to the fore in Fed communication during 2015, the market is forced to adjust to a new reality. Cheap credit will disappear, emerging markets may enter economic recessions, and US dollar strength is expected to increase as higher interest rates encourage foreign money to flow into higher yielding US investments.
The prospects are clear, but the start date of this new era is uncertain. Investors – large institutions – are positioning in anticipation of the renewed USD strength, but until the Fed announces the “lift-off” date, their positioning is precarious and at risk. Hence, there is a lot of hedging taking place in the market, as uncertainty and risk are prolonged by the Fed’s perceived indecision.
Popular hedges include gold, bonds and commodity currencies such as the Australian dollar, Canadian dollar, and developing market currencies. Conceivably, once the Fed fires the starter gun, the hedges will be cut, and value will flow back into the US dollar, sending it on a spectacular rally for the immediate future.
From the price charts, it is evident that, in its role as a commodity currency, bitcoin is also being used as a hedge and “safe haven”. While the market remains uncertain and subject to perceived Fed “indecision,” bitcoin (fundamental considerations aside) should continue rallying.
The irony of the current market condition is that the “lift-off” indecision is only a showpiece. The Fed is, in fact, already raising rates…
A quote from Senator Palpatine, I mean, Larry Summers:
[Outflows] means more and more downwards pressure on those [emerging-market] interest rates; means more and more upwards pressure on [or weakening of] those currencies; means more and more disinflationary and deflationary pressure; means more and more tendency, because of lost competitiveness, towards reductions in demand, and towards increases in supply.
Image from Shutterstock.
Last modified: January 25, 2020 11:11 PM UTC