Market attention is now on the US Federal Reserve meeting that will be held June 16-17. It appears that a rate hike is coming closer as indicated by various data and Fed chief Janet Yellen’s remarks.
However, the old-time market system of pricing rates may already be distorted after six years of QE. Therefore, investors should be wary of misunderstanding the intention of the Fed, which has yet to kick off the rate hike even as a liquidity drain is already emerging.
The Fed Fund Futures rate data shows that the rate hike won’t happen in June. Nevertheless, the chance of a rate hike before the year end has increased to 60 percent now, from 45 percent in mid-May, as a result of encouraging economic data recently. And the odds for a rate hike in the first quarter of next year have even soared to 80 percent.
The Taylor rule, proposed by John Taylor, shows that the target Fed Funds rate should be 2.3 percent based on current Core Personal Consumption Expenditures (PCE) and unemployment rate. That was 200 basis points above the existing rate, almost a record high level.
Given this, the Fed is set to tighten its monetary policy, especially as the labor market is improving.
If the central bank only raises the target Fed Funds rate, it will merely have a psychological impact on the market instead of causing a considerable drain on market liquidity.
US Aggregate Reserves Depository Institutions Excess Reserve, the reserves in the banking system, has skyrocketed in the wake of the financial crisis and surged to US$2.5 trillion. Therefore, it’s almost mission impossible for the central bank to tighten market liquidity only through hiking the target Fed Funds rate.
That being said, the Fed is more likely to unveil a set of monetary measures to cap the market liquidity. That will include offloading bonds and mortgage-backed securities (MBS), increasing the rate of interest on excess reserves (IOER) from the current 0.25 percent, and using reverse repos to adjust short-term rates.
The impact of the expected US rate hike is already starting to emerge following remarks by Yellen and other Fed officials.
Capital outflow from emerging markets continues. The Fed has cut its bond-purchasing scale from late 2013 and even halved the buying to less than US$40 billion each month since the second half of last year. And the loose market liquidity started to reverse. As a result, capital continues to flee from emerging markets since mid-2014.
Asia Currency Index (ADXY) and JP Morgan Emerging Markets Currency Index have seen a slide since the middle of last year, and the latter even registered a decline of over 20 percent, in a sign that foreign capital is leaving emerging markets.
Meanwhile, benchmark US Treasury yield, which has spiked to close to 2.5 percent from a bottom of 1.64 percent at the year’s start, has jumped over 50 percent within five months. The uptrend is likely to extend, which may affect the financing costs for bond issuers and long-dated mortgage rates.
This article appeared in the Hong Kong Economic Journal on June 11.
Translation by Julie Zhu
– Contact us at email@example.com