Hawkish Fed Exacerbates Dollar Fears for Emerging Markets
For emerging markets, the Fed just added insult to injury.
"The risks of gray or black swans – negative spill over from the dollar or from U.S. rates upon the rest of the world — was just jacked up a notch," Martin Enlund, chief currency strategist at Nordea Markets, wrote in a note to clients. "Will global markets positively digest this hawkish message; or will something break? The latter is usually the case."
The greenback extended its gains, while emerging market stocks staged a retreat, after the Federal Reserve's only interest-rate hike of 2016, which was accompanied by a signal by the U.S. central bank of three increases next year. The Fed meeting comes hot on the heels of a tumultuous week for Chinese markets, with the yuan falling to its lowest level against the dollar since June 2008, amid a liquidity squeeze. The U.S. dollar index is now at its highest level since Christmas 2002.
"With markets embracing the Fed’s more hawkish tone, stale bond longs still being squeezed and a legion of dollar borrowers likely to find refinancing more difficult, the stage is set for tales of dollar shortage and generally, a dollar overshoot," Société Générale global strategist Kit Juckes wrote in a note to clients, as the euro fell to its 2003 level against the greenback.
"We are getting tightening from a stronger dollar and steeper [U.S.] yield curve now. That's the biggest risk for 2017," Marios Maratheftis, chief economist at Standard Chartered Plc, said in an interview with Bloomberg TV.
Unless the U.S. boosts global aggregate demand by importing more from the rest of the world, trade tensions and expectations of yuan weakness will gather steam, analysts at Macquarie Group Ltd, led by Viktor Shvets, wrote in a note. Economists reckon the former prospect is unlikely. The U.S. current account deficit will barely budge over the next two years, staying at this year's level of 2.6 percent of GDP in 2017, rising by a sliver at 2.8 percent in 2018, according to median projections in a Bloomberg survey.
"If the U.S. proves itself unable to generate sufficient momentum to widen current account deficits and inject stronger demand and dollars into the global economy (thus keeping dollar supply low) and spreads widen, dollar appreciation could accelerate, curtailing global demand and liquidity," Shvets' team wrote.
The first quarter of 2017 could see a repeat of the EM selloff early this year, analysts at Goldman Sachs Group Inc warned in a note on Thursday, citing the prospect that Fed-fueled dollar strength pushes capital out of China, destabilizing the yuan.
Amid expectations of fiscal stimulus and protectionist policies under President-elect Donald Trump, the dollar has staged an advance over the past month at the expense of emerging markets, raising projections for the U.S. rate path even before this week's hawkish meeting. Over one-third of participants in Bank of America Merrill Lynch's monthly survey of money managers reckon long U.S. dollar positions are now the world's most crowded trade, with the percentage of participants who think the currency is overvalued at its third-highest level in a decade.
The jump in the outstanding stock of dollar credit offshore means "dollar strength is a far greater restrictive influence than it has ever been during the era of floating exchange rates," as the premium for debt-servicing increases in local-currency terms, Gaurav Saroliya, economist at Lombard Street Research wrote in a note this week.
Citing the prospect of a slowdown in trade financing and cross-border bank lending, Saroliya concludes: "Before long, the Fed may have to seriously consider becoming a key provider of global dollar liquidity. Or runaway dollar strength will stop further [Fed] policy normalization right in its tracks."