LONDON (Reuters) - The world economy was in an unusual position last year, posting “synchronized” growth for the first time since the 2007-09 crisis. But there’s been no synchronized tightening of monetary policy this year, and by going it alone on raising interest rates the Fed risks hastening the end of that cycle.
The divergence between the Fed and other central banks is fostering division at just the wrong time, as the dark clouds of currency and trade wars gather over the world economy.
Higher U.S. borrowing costs and the stronger dollar they deliver are an effective tightening of global financial conditions. Emerging markets, in particular, are vulnerable, and it’s little surprise they have suffered most recently.
The Chinese yuan’s slide is ringing alarm bells, India’s rupee is at a record low, Indonesia’s rupiah is close to 20-year lows, and Chinese and Brazilian equities are in bear markets. In the developed world too, bank stocks are buckling under flattening yield curves and the growth outlook is dimming.
To be sure, the U.S. rate-raising cycle has been and remains glacial, certainly by historical standards. And weaker exchange rates across the developed and emerging world against the dollar will offset the hit to growth from tighter U.S. monetary policy.
The synchronized growth of last year has already started to fray, especially in Europe. So while the Fed is already far further down the road of post-crisis policy normalisation than its peers, the gap may be about to widen further.
The IMF noted this week that the Fed should continue raising rates gradually “while being mindful of potential global spillovers”. But heavy U.S. fiscal stimulus “would likely require a faster pace of policy rate increases”.
As Bryan Carter, head of emerging markets fixed income at BNP Paribas Asset Management, points out, any “internationalist” outlook the Fed may have had in recent years has evaporated with the arrival of Jerome Powell as chair.
In his view, the Fed is now less likely to take its foot off the accelerator if emerging markets really start to crumble as a result of U.S. tightening than it might have been under Janet Yellen or Ben Bernanke.
“The Fed itself has become much more introverted and domestically oriented under Powell, and so maybe this time will be different,” Carter said. “That is very worrisome for me.”
SLOW-MOTION CREDIT CRUNCH
The dollar has gained 7 pct in barely three months as the Fed pulls away from the rest of the world. The Bank of Canada and the Bank of England have also raised rates, but neither anywhere near as much as the Fed, while the ECB has effectively said it won’t be raising rates for at least a year.
All three want to end crisis-era stimulus. But they’ll all welcome the growth-supportive lower exchange rates that the U.S.-rest of the world rate divergence is delivering.
Emerging market central banks are in a much trickier position. Governments and companies in these countries borrow heavily in dollars, so a weakening domestic currency increases their debt-servicing costs.
Once it starts, a sliding emerging market currency can be very hard to stop. Capital flight - from international and domestic investors alike - can quicken it, and central banks rarely manage to reverse it.
The examples of central banks across Latin America and Asia burning tens of billions of dollars of FX reserves in a vain attempt to prop up their currencies and stem the flow of cash out the country are too numerous to mention over the last 25 years.
Central banks can track the Fed and raise rates, but that could choke off growth. Or they allow the currency to weaken, running the risk that it spirals out of control and inflation takes off, forcing them to dip into their FX reserves.
It all adds up to a perilous climate for investing. Pointing to the “triple shock” of tightening financial conditions, higher oil prices and risk of a trade war, HSBC strategists reiterated their conviction that bond yields and curves will stay low.
They say the 10-year U.S. Treasury yield will fall to 2.30 pct by year-end from 2.85 pct currently, and the yield curve will flatten to 10 basis points from 30 bps now. To give an idea of how much of an outlier that 10-year yield forecast is, the consensus in the latest Reuters poll is 3.20 pct.
“Over the last six months we have compiled a long list of individual surprises which appear to be more than coincidental,” they wrote on Wednesday.
“When viewed alongside the decoupling of growth paths, tightening U.S. financial conditions and re-pricing of risky assets, we have all the hallmarks of a slow-motion credit crunch.”
— The opinions expressed here are those of the author, a columnist for Reuters —
Reporting by Jamie McGeever; additional reporting by Karin Strohecker; editing by Andrew Roche