LAST Thursday was a watershed moment in the world of international finance and economics.
The Federal Reserve (Fed) announced the start of an exercise to reduce its balance sheet, meaning the end of an environment of ample liquidity in the United States financial system. It is the end of an era where the central bank of the world’s largest economy pumped the system with money to reflate the economy as a response to the 2008 financial crisis.
Following the Fed’s announcement, the US dollar index, which measures the greenback against a basket of other major currencies, inched up a little to 92.25 points. However, it declined a day later to 91.86 points, which is not far from its low of 91.35 recorded on Sept 8 this year.
The Fed also indicated another hike in its interest rates – the third increase this year. When that happens, the Fed rates are expected to be between 1.25% and 1.5%. Next year, the Fed is looking at another three rate hikes – pointing to the federal fund rate to be between 2% and 2.25%.
The question that the other financial markets around the world are grappling with is whether the Fed’s move to reduce its balance sheet would result in the long-term strengthening of the US dollar.
Would continuous interest rate hikes result in the unwinding of more carry trade and outflow of funds from the emerging markets?
And would a series of interest rate hikes in the US have a positive impact on strengthening the dollar?
There isn’t a straight answer to these questions. For instance, the Fed has raised rates twice this year but the dollar has weakened against currencies such as the ringgit because of the lack of confidence in the unpredictable economic policies of President Donald Trump.
However, the measures of the Fed certainly point to the central bank wanting to see the US and global financial environment go back to the norm. It wants to see the end of the ultra-low interest rate regime and ample liquidity in the system.
The actions of the Fed would contribute to the dollar appreciating to its true value. And based on history, the Fed always gets its way.
A strong dollar goes against the grain of President Trump’s economic reform policies. The controversial US president wants to see a weak dollar to strengthen exports and plans to boost the economy via reforms in the tax system and infrastructure spending.
The divergent policy measures fuelling speculation that Trump will replace Fed chairman Janet Yellen by year-end is picking up pace.
However, if Trump does not replace Yellen by year-end, then the US financial environment will start its trek back to normalcy. Interest rates will start rising and gradually, there will be less liquidity in the system.
This is because beginning October, the Fed will start to shrink its balance sheet of US$4.5 trillion by reducing its re-investment in Treasury bills and mortgage-backed securities (MBS) every month.
The re-investment has been capped at US$6bil a month for Treasuries and US$4bil a month for MBS.
The Fed is hoping that a reduced balance sheet and a rise in interest rates would lead to inflation hitting its target of 2% per annum.
So far, inflation in the US is hovering at less than 2% despite the unemployment rate coming down and the economy growing. This goes against the text-book economic theory that economic growth, jobs, wages and inflation are all connected.
When the economy grows, more jobs are created. It gives rise to higher wages and fuels inflation. However, this is not happening in the US.
In the US, unemployment is between 4.3% and 4.4%, with new job creation averaging 175,000 a month. It is well above the full employment figure of 100,000 to 120,000 per month. However, core inflation is less than 1.5%.
This has left central banks worried if the policies that they took to reflate the economy in the aftermath of the 2008 financial crisis have brought about long-term negative consequences to the global economy.
To the uninitiated, when the financial crisis blew up in 2008, the Fed embarked on a twin approach – which is to pump liquidity into the system through quantitative easing (QE) and adopting ultra-low interest rate policies.
All major central banks took the approach of adopting an ultra-low interest rate policy. The European Central Bank, Bank of Japan and to some extent the Bank of England followed the measures.
This resulted in an outflow of money from developed markets to emerging markets, where returns on assets are higher. Investors raised money in countries where interest rates were low and ploughed them back into countries where there were assets with high yields.
Malaysia was a beneficiary of a huge inflow of funds. The ringgit strengthened and property prices gained.
Foreigners invested in a large portion of Malaysian government debts that offered yields of more than 3% because they borrowed at less than 0.5% in the US, Japan and Europe.
Since 2013, the funds have been flowing out of emerging markets such as Malaysia.
The outflow has reduced in the last four months because of uncertainties in the US monetary and fiscal policies. The reduced outflow has helped Malaysia’s international reserves improve to about US$100bil currently. Malaysia’s healthy exports also helped to strengthen the reserves.
The ringgit is now at about RM4.20 to the dollar. Even the Chinese yuan has appreciated against the US dollar despite the country facing a host of problems with its over-geared private sector.
But the appreciation in emerging-market currencies is unlikely to last long. The outflows are likely to resume when the US starts its interest rate hikes and tightening of the QE in October.
The currency markets will roil again as outflows gain momentum. It will continue until the market adjusts to the new norm of the US dollar. As an analyst has put it – watch out for the new recalibrated US dollar!