Harvey and Irma Have Global Market Implications
The term “butterfly effect” was coined to describe how a hurricane’s intensity could be influenced by the fluttering of a distant butterfly’s wings. In the wake of the recent devastation by Harvey and Irma, we may have to contend with the widespread reverse impact that hurricanes could have on global financial markets.
The human tragedy of lost lives and the millions who were dislocated by the floods is only one consequence of the natural disasters. The financial press has also noted the likely dip in U.S. economic growth in this current quarter due to lost productivity, offset by a pickup in jobs and production in the final quarter of the year. This would make it seem that there will be no lasting effect on the economy or markets.
That conclusion would be a serious error. Hurricane Harvey has already been a major factor in President Donald Trump's ability to reach agreement with Democratic congressional leaders to fund the government through mid-December. The storms could also affect decision-making in three major central banks, influencing the future direction of currency exchange rates, as well as global equity and bond markets.
Even if the Federal Reserve announces a paring of its balance sheet at the end of its two-day meeting on Sept. 20, it may well be forced to delay future rate hikes until the full impact on U.S. gross domestic product and employment becomes clear. A dovish Fed statement about the pace of future rate increases would revive expectations of a “Yellen put” and propel equities higher. For bond investors as well, postponement of the next rate hike would be a bullish signal. Treasury yields have risen in recent days but could turn lower again.
The reverse butterfly effect does not end there. The euro has appreciated significantly in recent months (chart below), rising above $1.20 due both to investor optimism about Europe and falling expectations of a Fed rate hike in December. This raised concerns from Benoît Coeuré, a member of the European Central Bank’s Executive Board, that the strong currency could lower euro-zone inflation further below the central bank’s long-missed 2 percent target. If the Fed decides to wait until the full impact of the hurricanes is known, the euro is likely to strengthen further, hurting the ECB’s efforts on the inflation front.
The ECB had been widely expected to announce at its meeting on Oct. 26 that it would taper monthly bond purchases from the current level of 60 billion euros ($71.74 billion) effective next January, as well as suggest when the historically low interest rates would be increased. By messing with central bank policy, Harvey and Irma may cause easy monetary conditions to persist in the euro zone.
The hurricanes’ impact may be felt far afield, with the People’s Bank of China being the major beneficiary. Stringent controls have helped China avoid a repeat of the massive capital outflows that occurred in late 2015 and early 2016, and helped stabilize the currency. A signal that U.S. interest rates are not going up anytime soon would give Chinese authorities more time to deal with important domestic issues such as the surging shadow banking debt (chart below) without having to worry about the external sector at the same time.
The fallout for investors from the hurricanes is likely to include a delay in the normalization of interest rate policies by central banks, and a strengthening of ongoing factors such as a weakening dollar. Asset valuations, which Fed Chair Janet Yellen termed “somewhat rich” in June, may get richer still. And the urgency of having to deal with issues such as the size of the Chinese domestic debt will dissipate to some extent due to the continued ease in U.S. monetary conditions.
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