Fed may be the least of investors’ concerns in 2016
On Wednesday, international investors witnessed the financial equivalent of a space shuttle launch when the US Federal Reserve, the world’s most important central bank, increased its benchmark interest rate for the first time in nearly a decade, putting an end to seven years of zero interest rate policy (ZIRP).
Make no mistake about it, the 25 basis point increase in the Fed’s overnight federal funds rate target is a historic decision that has already had a major impact on capital flows and foreign exchange markets the world over.
It has also been the longest-awaited and most painstakingly telegraphed tightening in monetary policy in the history of modern central banking.
Unlike the “taper tantrum” triggered by the Fed’s unexpected decision in May 2013 to start winding down its programme of quantitative easing (QE), the surprise this time round would have been if the Fed kept rates on hold.
The benchmark S&P 500 equity index rose 1.5 per cent by the end of trading on Wednesday while the Vix index, Wall Street’s so-called “fear gauge”, fell 15 per cent to just under 18 - below its historic long-term average of 20.
This was a US rate hike that investors were entirely prepared for and have wanted the Fed to get out of the way in order to put an end to the perennial uncertainty.
Yet incessant speculation about the precise timing of the Fed’s “lift-off” has been unhelpful, not least since other vulnerabilities and stresses have proved as important - if not more - in shaping sentiment over the past several months.
The dramatic decline in oil prices - on Wednesday, Brent, the international benchmark, fell a further 3.3 per cent to $37.19 a barrel, just a tad higher than the seven-year low reached on Monday - has already had a stronger bearing on market conditions and has been the trigger for the alarming sell-off in the US high-yield (or junk) bond market over the past week.
Following the decision on December 10 by Third Avenue, a US asset manager, to shut down its US $790 million “Focused Credit Fund”, a wave of redemptions - which have since forced two other US credit funds to close - has sparked fears about some of the riskier parts of the global debt markets.
Such is the level of concern about the US junk bond market that parallels are now being drawn with the “sub-prime meltdown” in the US residential mortgage market in 2007 which brought about the global financial crisis.
High-yield bond spreads have widened sharply this year (particularly over the last two months) as a sell-off in the ailing energy sector spreads to other industrial sectors which hitherto had remained relatively unscathed. This has placed bond portfolios and popular Exchange Traded Funds (ETFs) that track the junk bond sector under severe strain amid a dearth of liquidity in debt markets.
George Magnus, a prominent economist, notes in his blog that “when redemptions from any particular fund start, there’s a danger of contagion, as we have started to see in the last few weeks.”
The second source of vulnerability is China - particularly its currency which has already fallen 2.4 per cent against the dollar since the end of November, increasing the scope for further capital outflows and putting more strain on emerging Asia’s other currencies.
Indeed as JP Morgan notes in a recent report: “the outlook for [emerging Asian] currencies in 2016 almost starts and finishes with the outlook for the [yuan].” Persistent concerns about a harder landing for China’s economy, coupled with the potential for a stronger dollar due to increasing divergence in global monetary policies, are likely to maintain downward pressure on the renminbi next year.
Then there is the plethora of geo-political and country-specific risks, ranging from the terrorist threat posed by Isis to the rapidly escalating political and economic crisis in Brazil.
Still, at least the Fed’s decision was in line with market expectations and, given the central bank’s aim of tightening policy only gradually, should help offset the negative factors weighing on sentiment.
The question, however, is whether the Fed was right to raise rates at a time when market conditions are extremely fragile.
This will only become clear at the beginning of next year.