by NGOC ANH 25/10/2021, 11:10

Some trepidation towards FED’s monetary normalisation

Global investors might be looking with some trepidation towards monetary policy normalisation by the Fed.

International investors might be looking with some trepidation towards monetary policy normalisation by the Fed. 

Such periods can see significant tensions, especially in emerging markets and often revolving around a stronger dollar. But this time around, Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks that there are two reasons for optimism. The first of these is that the Fed is likely to tread very carefully indeed as it nudges policy back to a tighter setting. The second is that, even if it does move a tad faster than expected, we don’t expect any significant dollar shortage problems to arise that could cause the dollar to soar.

On the first of these, Mr. Steve Barrow has undoubtedly seen inflation rise dramatically in the US as, indeed, it has in many other nations. Some of these other countries have hiked rates (NZ and Norway) while others have started to taper bond purchases (Australia and Canada). Others look set to start lifting rates soon (the UK), but the Fed has sat tight and only seems likely to signal QE tapering at the November meeting, to start in December.

“We know that through this tapering period, the Fed won’t lift rates. Members have said as much. They could go back on their word but that’s very unlikely in our view. Hence, between now and the end of tapering, which will probably be around the middle of next year, we can be pretty certain that the Fed won’t hike rates and, in the meantime many other central banks will be bolstering their currencies by raising rates. Of course, the Fed could speed up tapering significantly and so bring forward the first rate hike but our sense here is that the Fed is far more cognisant of the damage that such monetary policy surprises can do to global financial markets, and hence the US economy, than other central banks thanks to the dominant global role of the dollar and dollar borrowing. Hence the Fed will be patient; more patient than many other central banks and we think that the cost of this will be low real rates in the US; something that will keep the dollar becalmed”, Mr. Steve Barrow said.

But what if the Fed is just a tiny bit more impatient than the market expects? Could this be sufficient to make the dollar surge and crater risk assets like stocks and emerging markets? It is possible, but one thing we have noted in the past is that the scope for adverse events to create a ‘dollar shortage’ problem, as traders, investors and borrowers seek the safety of the greenback, or try to pay down dollar debt quickly, has been reduced by Fed actions. The Fed’s central bank swaps with other central banks and last year’s announcement of a treasury repo facility with central banks seem to have helped prevent an escalation in the cost of acquiring dollars during the Covid crisis.

“We feel that if the Fed were to push rates ahead a bit faster than the market anticipated these swap/repo cushions would help prevent a disastrous surge in the greenback. This being said, we can’t deny that financial markets really are at a crucial point right now. A best-case scenario is that supplychain pressures eases, inflation comes back down and the Fed can withdraw stimulus at a slow and steady pace as the economy continues to improve. The worst case is that either supply strains intensify, or the inflation already embedded by the supply chain difficulties leads to second-round effects such as surging wages that push inflation further away from the Fed’s longer-term forecasts. Even in such a scenario we don’t believe that the Fed will slam on the brakes and that the Fed’s swaps and repos will cushion international markets”, Mr. Steve Barrow stressed.

Nonetheless, from a risk/reward perspective, investors have to ask themselves whether it is possible for them to make a judgement between these two scenarios right now, or whether it is best to wait and see how things play out on the inflation front. For those that want to hold riskier assets this could mean forsaking profits, but it is a price worth paying as it is a brave call to suggest that price pressures will melt away in the manner that the Fed seems to think.