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There seems to be limited risk of the Fed raising rates repeatedly & rapidly, or of other central banks turning off the taps anytime soon, says Akash Prakash.
It is by now quite clear that in all likelihood the US Federal Reserve will hike interest rates in its next meeting in mid-December.
Unless we see some sudden collapse in economic activity in the coming weeks, global volatility or an unexpected deceleration in jobs growth, the Federal Reserve will hike by 25 basis points on 16 December.
Governor Janet Yellen seems determined to get this done once and for all, and change the debate.
Having got the bogey off their back of whether and when the Fed will hike, there are now two things for investors to ponder: first of all, what is the likely pace and quantum of rate hikes once this first move is done; and, second, what is the likely impact of the rate hike cycle on risk assets more broadly.
On the first point, it is quite likely that we will see very limited rate hikes and that too in a very slow and measured manner.
Given the weakness in the global economy, the continued fears around the emergence of a deflationary cycle and lack of confidence in the sustainability of a US recovery, no one wishes to risk a growth relapse. The fact is that, were growth to slip, there is almost no policy ammunition to counter a mistake.
The IMF has in fact been going to town discouraging the Fed from any hike, citing the risks to emerging markets and the global economy of hiking too quickly.
Many influential economic commentators in the US are convinced that trend rates of growth have structurally declined and that we are in the midst of secular stagnation.
They also counsel caution in raising rates.
The Fed, while aware of the risks of extremely low rates, seems keen to ensure that inflation gains hold and actually accelerate rather than focus on the consequences of low rates in encouraging poor capital allocation and financial market bubbles.
They seem either unaware or oblivious of the consequences of extremely low rates. Savers, be they institutional in nature like the pension plans and insurance companies or individuals have been slaughtered by this move to zero or negative interest rates.
You are also hollowing out longer-term growth by frontloading consumption and encouraging misallocation of capital.
There is a price that all of us will have to eventually pay for this extended period of zero rates.
Unlike in the past, when central banks around the world would always look to be pre-emptive in hiking rates, try to be ahead of the curve, worry about their inflation-fighting credibility and keep the leads and lags in monetary policy transmission in mind, today it almost seems as if the Fed and other central banks are keen to consciously fall behind the curve and let inflation gain momentum and re-enter consumer and business expectations.
They seem less worried about getting behind the curve than about making sure that deflationary forces do not gather strength.
There seems to be limited risk of the Fed hiking rapidly, or of other central banks turning off the taps anytime soon.
On the second point, there is almost universal belief that with the Fed hiking rates and the ECB (European Central Bank) likely to further increase their QE (quantitative easing) programme and negative interest rates, the US dollar will strengthen and equities broadly but especially in emerging markets (EM) will weaken.
The outlook for other EM assets and global commodities will also be challenged in a world with a strengthening dollar.
EM assets rarely do well in a strong dollar environment and many investors feel the biggest bubble in this cycle may actually be in EM debt.
This is probably the single most crowded and consensus trade in the market today (strong dollar, weak euro, weak EM).
There is, however, also a contrary view out there. The bulls point to how asset prices moved in the three years post the Fed hiking rates in June 2004 and February 1994.
They argue that these two episodes are the only ones relevant when considering the current cycle and environment.
In both these cases the Fed moved after a long period of very low rates. In both cases Japanese and European monetary policy stayed easier than the US and their respective central banks moved much later.
Contrary to popular belief and current investor positioning, in both 1994 and 2004 the dollar weakened almost immediately after the first rate hike by the Fed.
It stayed below its starting level all through the three years. A classic case of markets having fully priced in future expectations and peaking out before the fact, and the need to sell on the event itself.
Equity markets stayed broadly stable for the first 12 months post the hikes and then delivered strong positive performance across regions. There was no regional pattern, with US equities leading the way in 1994 and Asia delivering the best positive performance in 2004.
On both occasions, bonds were lacklustre and delivered little positive performance. Obviously the past may not be repeated, and one can question any conclusions based on only two data points, no matter how similar to the current environment they may be. However what is clear is that it is by no means inevitable that the dollar will strengthen, equities weaken and EM assets come under pressure.
There have been periods and cycles similar to today(though less extreme in monetary activism) when the exact opposite has happened.
Given how crowded the strong dollar trade has become, and the pervasive bearishness on all EM assets and growing fears on equities more broadly, it is worth thinking through an alternative scenario.
The pain trade for global investors would clearly be if the pattern of 1994 and 2004 were to be repeated.
Most people are not positioned for dollar weakness and global equities and EM strength. A case can also be made for moving money into EU and Japanese equities, given where they are in their business and profits cycles and relative valuations.
If global equities hold up and the dollar stays stable, international markets will likely do better than those in the US.
Photograph: Reuters
Akash Prakash is at Amansa Capital. These views are his own.
