FED: If In Doubt Leave Well Alone

  • Ignoring China causes financial pain
  • China reverses yuan slide to head off currency war
  • U.S Economy looking progressively healthier
  • Investors seek Fed guidance in Wyoming

The global investor cannot afford to ignore what’s happening in China. The world’s second largest economy, or first depending on whom you talk to, has a massive impact on global dynamics and asset prices. This week’s market action has been a rude awakening for anyone who, up to this point, has paid scant attention to China. The market had become so accustomed to double-digit growth that 7% is now a major problem.

Obviously the issues are much deeper than just economic growth. China is new to capitalism and extreme movements in its market will probably become a more common sight, given its peculiarity of being dominated by small-time inexperienced investors.

Traditional monetary policy easing is not sufficient to mitigate the risks associated with China’s highly leveraged economy. It needs to change the playbook and remove some of the restrictions that hinder foreign ownership of shares; 98% of the domestic market is in the hands of local inexperienced investor. All of this takes time and it’s a process that the rest of the world must buy into.

China Changes Course

Last year China accounted for 40% of global growth; when they have issues so do the emerging economies and eventually the rest of the developed world. So what Chinese authorities do or say now has material global impact. The one major advantage of being a single party state is that you can reverse a decision much more quickly than in a democratic union. After just one week, China has been so surprised by the global reaction to its currency devaluation that it is likely to keep the yuan on a tight leash in the near-term, to head off a currency war that could spark a broader financial crisis.

FED’s Rate Normalization Policy

The world is looking to the Fed. Will Janet Yellen and company hike U.S rates in September or has this week’s wild swings in world financial markets persuaded them to hold off?

The Fed Chair has gone to great lengths to convince markets that the Fed means business and is ready to lift short-term rates this year. Yellen has argued on many occasions that acting sooner would allow U.S policy makers to tighten gradually. It’s the word “gradually” that capital markets seem to keep missing.

The Fed is in a tough spot; the domestic U.S economy is looking progressively healthier and there are many arguments to suggest that the U.S domestically could support a “token” rate hike. The Fed has virtually completed step one of its dual mandate, full employment. Its inflation target still requires some work. As long as commodity prices do not keep going south, then they should eventually be able to tick off that box too. Even data on Thursday showed that the U.S economy grew much more quickly than first estimated in Q2, rising by +3.7% vs. +3.2%. U.S exports to China represent only +1% of its GDP, meaning the direct impact of the Chinese economic woes looks modest.

Fed Has Time

However, it’s the effect that China has on the EM and the rest of the world that would have a material impact on the U.S. So the Fed has to tread carefully; it wants to deflate a potential bubble and not burst it. If it were not to act this year, their credibility will certainly be called into question.

The market is looking for guidance and many are hoping that there will be clues this weekend at Jackson Hole, Wyoming. With a number of Fed members skipping the symposium, chair Yellen included, the spotlight will fall on vice-chair Stanley Fischer’s inflation speech on Saturday.

The immediate problem for the Fed is the uncertainty about how serious the Chinese downturn will prove to be. Chinese leadership is being tested, as investors seem to be losing confidence in Chinese authorities and continue to want to cash out as doubts over the effectiveness of Government policies continue to get bigger. One thing for sure is that a one party system will not allow their policies to fail.

For the Fed, given the recent market mayhem, it’s probably more prudent to see how the markets react to this month’s data than to push forward with a hasty rate increase that could only add to the confusion. Perhaps the Fed should be looking to October, a no press conference meet, if its their intention to hike this year. Capital markets tend to struggle in the month of December from lack of liquidity, and the Fed would rather not be a market mayhem instigator.

Forex heatmap

Dean Popplewell

Dean Popplewell

Vice-President of Market Analysis at MarketPulse
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell