This week has been anything but peaceful for financial professionals across the globe. After months of sending blurred messages about the direction of the Fed’s monetary policy, Janet Yellen has finally given the markets something more substantive. Noting that a December hike was now a “live possibility”, Ms. Yellen reiterated the Fed’s focus on the labour market. The ultra-strong US jobs report that went public on Friday became for many a clear signal of the first wave of tightening this winter.
With one month still to go until the possible hike, it is perhaps a good time to voice a few words of caution regarding the repercussions of such a policy move across the global financial system. First of all, higher rates imply higher demand for dollar-denominated assets. This will trigger a noticeable exodus of investors from fixed income securities in other parts of the world, moving their capital across the Atlantics in pursuit of higher yields.
This might be a good argument for Mario Draghi to keep his foot hard down on the accelerator, as the projected outflow of capital from Europe might wipe off a substantial part of QE gains, sending yields up and prices down after months of aggressive purchasing from ECB. Moreover, the real danger may even be not in the US at all. After a crackdown in emerging markets this summer, vast capital outflows ensued, leading to plunging national currencies and central banks tapping into their currency reserves attempting to stem the nosedive. As those reserves are mainly kept in a form of government debt of developed economies, ECB bonds took a severe hit among others. According to some estimates, the scale of the selloff of debt formerly kept as reserves was large enough to easily negate the whole impact of QE. It is hard to predict the magnitude of such selloff associated with a rate hike in the future, but this is something that European policymakers should definitely keep on their radars.
Next, substantial capital inflows will contribute to further dollar appreciation, which in fact has already started as the dollar climbed 1.19% last week, measured against a basket of other currencies. For the US itself consequences did not take too long to come, with S&P 500 dropping 0.4% immediately after J. Yellen’s testimony on Wednesday. Equities are pulled down by two main factors: (1) higher costs of borrowing that might leave a significant trace on companies whose balance sheets have become overloaded with “cheap” financing that has been around for nearly a decade, and (2) stronger dollar that might impair their competitiveness against their foreign counterparts. Equity analysts are already placing bets as to which companies and sectors will be hit the most.
While on the topic of competitiveness, with QE showing no signs of abating and tightening on the other side, European companies will avail themselves of a cheaper Euro. While it is too early to track any major effects yet, this year we have seen that plunging Euro can have a significant impact on European equities. Termed by some economists as a “beggar-thy-neighbor” policy, the policy of competitive devaluation is generally quite a dangerous way of gaining a competitive edge, as it usually results in a currency war where the stronger economy always wins. The discrepancy in monetary policies across the Atlantics will inevitably create conditions similar to a competitive depreciation, but with no ominous consequences. This then could be a great chance for Europe to break free of its sluggish 0.XX% growth, albeit at the expense of the US economy.
Lastly, the appreciation of the dollar will trigger one more important process on the opposite side of the globe. With China tacitly but consistently fixing the renminbi to the dollar, a more expensive dollar will immediately translate into a more expensive Yuan, further curbing Chinese exports after an already massive drop of 6.9% year-on-year in October. Controlled depreciation of Yuan is not an option either, as China still remembers the consequences of such a bold move this August (when a 3.5% depreciation of Yuan caused chaos on the trading floors across the world). A stronger renminbi will not take long to find its reflection in the Chinese economy’s performance, casting shadows once again on the world’s economy as a whole.
Conclusion time. Should the American policymakers bear in mind the potential effects of a rate hike? The answer to that is a definite “yes”. Should they delay or cancel the tightening because of these considerations? At this point, the answer to that is rather “yes” than “no”. Stuck between the fears of ruining the recovery and letting the economy overheat, J. Yellen’s office have been playing chicken with investors for far too long. A gradual, well-paced and clearly communicated increase in key rates will without doubt have a better effect on the markets than months of nerve-racking uncertainty. How much better? Let us wait till 2016 and find out.
 Multiple economists refer to this process as a “quantitative tightening”, which it, in effect, was!