Who's Afraid of Fed Rate Normalization?


Jeff Klingelhofer, CFA

Taking "international developments" and "financial conditions" into account, the Fed appears inclined to engineer a rate normalization that doesn’t spur sharp dollar gains, helping relieve a headwind in emerging markets.

The summer of 2015 was dark and stormy for investors. China's equity market collapsed, and the surprise renminbi devaluation shook currency markets across the globe. The U.S. Federal Reserve pulled the rug out from under those following its previous guidance for a September "lift-off" in key interest rates. Oil prices continued to slide. The descent in emerging market currencies quickened, and corporate credit spreads sharply widened, among other risk-off reactions that left few areas of risk markets unscathed. Looking back, it isn't clear what sparked the risk assets wildfire. I will, however, speculate that the main culprits for the initial selloff were the sudden Chinese currency devaluation, which stoked fears of a significant acceleration in capital outflows from China amid slowing domestic growth, and the pressures on growth from the strong U.S. dollar—to which the renminbi had been tethered and in which commodity prices are denominated and negatively correlated. These are probably part of the reason the Fed stayed its hand in September. Following their monetary policy committee meeting that month, Fed officials stated they would assess the effects of "international developments" and "financial conditions" on progress toward full employment and stable prices ahead of their December 16th meeting.

Risk assets, including many in emerging markets, have rallied subsequent to the September Fed meeting. One potential reason for the rise in investor confidence is the Fed's acknowledgement surrounding the two key areas mentioned above: "international developments" (Chinese and other global markets) as well as "financial conditions" (the U.S. dollar and credit spreads). Tying developments within these areas to monetary policy outcomes increases the likelihood the Fed pursues gradual monetary tightening, and thus ups the odds that interest rate "normalization" leads to less disruption in global markets. Were the Fed to move quicker than markets expect, we would likely see an adverse reaction from global markets and a strengthening of the U.S. dollar. Fed officials would view that as likely to slow the advance toward full employment and their 2% inflation target, and would then slow rate normalization. While I can make many arguments as to why Fed officials should be less concerned with controlling markets, the markets themselves would be right to take comfort from a down-shift in tightening. By this perspective, the Fed was probably right to err on the side of caution in September's meeting.

Only time will tell how the future unfolds and risk assets perform. But, as the Fed's December meeting approaches, we are likely to see further communication suggesting a gradual process of rate increases as Fed officials closely watch the evolution of global financial conditions—risk assets included. This, in turn, should nudge investors' mindset away from the exact timing of the first rate hike and toward ultimately what is more important for investment outcomes: the pace and ultimate extent of future tightening. Overall the slight step in the dovish direction taken by the Fed regarding the pace of increases should set a more favorable backdrop for emerging markets as we enter 2016. At the least, the strong headwind for emerging markets of ongoing dollar strength may lessen a bit.

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