16 September 2019
It is far from certain that the US dollar would strengthen after the Fed rate hikes. Photo: Bloomberg
It is far from certain that the US dollar would strengthen after the Fed rate hikes. Photo: Bloomberg

What will happen to Asia when US starts hiking rates?

The US Federal Reserve is almost certain to raise interest rates in its next board meeting on Dec. 16, with financial markets now pricing in a 75 percent probability of a rate hike.

Meanwhile, market expectations of interest rate cuts by the European Central Bank and the Bank of Japan have risen.

Three big questions arise: How far and how fast can US interest rates rise from here? How would asset prices react, especially those in Asia which had seen capital outflow over the past year due to worries over a US interest rate hike? Should Asian investors be worried?

Fed chairwoman Janet Yellen has argued that interest rate hikes this time would be slower and shallower than in any previous cycle, for good reasons. The explanation for this lies in the simple fact that the US economy is still stuck with a post-balance-sheet recession adjustment.

Such an adjustment process is characterized by deleveraging and slow economic growth and, hence, lack of inflation.

This is obvious in the United States, where household debt is being cut from more than 135 percent of GDP before the subprime crisis to about 85 percent now, and despite the return of some economic growth momentum, US inflation has stayed stubbornly at around 1.0 to 1.5 percent a year.

The Fed, like the Bank of Japan, is determined to push up inflation to a target of 2 percent a year and keep it there.

Under the current high-debt-slow-growth environment, the Fed must remain “behind the curve” of rising inflation, just as former Fed chairmen Paul Volcker and Alan Greenspan stayed behind the curve of falling inflation in the 1980s and 1990s, when the Fed’s overriding objective was to push down inflation and keep it low.

This is to say the Fed’s current job is to pursue a reactive policy to allow inflationary pressures (which so far have been lacking) to build up to reasonable levels rather than to pursue a preemptive policy to clamp down on inflation too early.

The lack of inflation and feeble growth simply put a ceiling on how far the Fed can raise interest rates.

How have the markets reacted to the Fed’s tightening in past, especially when the European Central Bank and the Bank of Japan pursued an opposite policy of loosening?

Everyone seems to believe the wrong answers: that Fed tightening leads to a stronger US dollar, weaker equity markets and financial trouble in Asia.

Here is the evidence from the past cycles:

The tightening cycles in February 1994 and June 2004 are the only episodes of US monetary tightening comparable to the one that is about to begin.

In both cases, the Fed started to raise interest rates after what seemed at the time to be unbelievably long periods of ultra-low interest rates.

Moreover, in both cases, European and Japanese monetary policies remained much easier than the US’s, just as they are today.

For example, in the 1990s, the Bundesbank continued to cut interest rates for more than two years after the US Fed had started raising rates; and in 2005, the European Central Bank lagged behind the Fed’s move to raise rates by 17 months.

In both cases, after the initial Fed moves in 2004 and 1994, the US dollar weakened almost at once after the first rate hike and stayed below its initial level throughout the following three years.

Equity markets traded sideways for between six and 12 months. After that they gained sharply, with the US market outperforming the global markets between 1995 and 1997 while Europe and Asia did much better than the US in the 2005-07 period.

On both occasions, bonds went nowhere.

Of course, past performance is no guarantee for future results. Just because the US dollar weakened in both comparable cases of past Fed tightening does not mean that it would weaken again this time around.

However, the evidence does show that it is far from certain that the US dollar would strengthen after the Fed rate hikes.

If the US dollar does stabilize or weaken after the first Fed rate hike, then it would simply reflect the situation that there would be no capital outflows from Asia and no weakening of the regional equity markets.

In that case, we may even see a strong performance by Asian (and European) assets in the current Fed interest-rate hiking exercise, as we saw in 2004 and 1994.

– Contact us at [email protected]


Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”