Why the Fed rate hike didn’t create a ripple

The US Federal Open Market Committee (FOMC) raised its target fund rate by another 25 basis points on Wednesday and put forth a detailed roadmap for trimming its balance sheet. Such hawkish policy would have sent financial markets reeling three-four years ago.

But investors absorbed the latest Fed action with an uncharacteristic nonchalance. Why are the investors unperturbed?

The first reason is the systematic manner in which the US central bank is going about policy normalisation, with detailed guidance given well in advance about the data-points it follows, the trajectory and the range of outcomes.

While hiking the Fed funds rate in the June meeting, the FOMC has indicated that the rate could move to 1.4 per cent by the end of 2017, gradually increasing to 3 per cent by the end of 2019. While the rate-hike schedule is contingent upon data releases on inflation and unemployment, spelling out the probable outcomes clearly has helped markets prepare themselves.

The Fed has also made it clear that it intends to shrink its assets, which increased from $865 billion in August 2007 to $4.5 trillion by end 2014. It plans to do this by not reinvesting the amount paid back on maturity.

Such payments will be reinvested only if they exceed certain limits. In treasury securities, the limit would be $6 billion per month, which will increase by $6 billion every three months until the cap rises to $30 billion per month. The limit in the case of mortgage backed securities (MBS) is set at $4 billion a month, to increase in steps of $4 billion every three months until it reaches $20 billion per month.

While the committee has not stated when these limits will come into force, many in the market expect it to be enforced by September this year. If that happens, the maximum monthly limit of $50 billion will kick in by September 2018. By the end of 2020, total assets of Fed would have reduced by $1.7 trillion, reducing the balance sheet size to around $2.8 trillion. Such staggered reduction is unlikely to roil financial markets.

Another reason why financial markets are unfazed is the diminishing relevance of dollar carry trade. In the period immediately after the crisis, the near-zero rate of interest in the US had given rise to dollar carry trade wherein investors borrowed in dollars to invest in assets across the globe, creating price bubbles in many assets.

But this concern no longer holds due to two reasons. One, the Fed funds target rate that was at 0.25 per cent from December 2008, has been rising since December 2015. The hike in the June 2017 meeting is the fourth since then. Carry trades generally unwind when borrowing costs move higher. Two, dollar has also been quite volatile since 2014, a feature that is not conducive to carry trades either.

Three, even as the Fed stopped its bond buying programme, other central banks such as the European Central Bank and Bank of Japan have been aggressively pumping liquidity into the system. The ECB’s $2.6 trillion bond-buying is set to run till year-end and the Bank of Japan is buying Japanese government bonds and ETFs worth around 90 trillion yen a year. Global investors, therefore, need not fret about liquidity draining out of the system as long as these banks continue monetary easing.

Four, other currencies such as the Australian dollar, New Zealand dollar, yen and euro have replaced the gap left by declining dollar carry trades since interest rates in these countries are still quite low.

Finally, bond and currency markets are being influenced by recent developments. US 10-year government bond yield has decreased from 2.4 per cent in mid-May to 2.16 per cent. These rates have been affected by two factors: one, the expectation that the Fed will not hike rates too aggressively this calendar. Two, dollar’s slide has also led to lower demand for US government bonds. When Trump took charge of the US, dollar rallied in anticipation of aggressive policies to boost growth. As these hopes faded, dollar has been sliding lower.

Fall in yields on US government bonds is, however, unlikely to affect Indian bond market that is currently being influenced by the falling inflation. The rupee, on the other hand, has been on firm wicket due to strong flows and reviving exports.

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