A ‘New Normal’ how Fed policy influences global financial markets

By: ECR_Research

The consequences of the ‘new normal’ (coined by El-Erian of PIMCO) are not limited to the US, but have profound implications how we need to analyze the world economy and financial markets.

The time has passed that the rest of the world followed the US economic cycle closely. The growth dynamic in especially the emerging markets have become much more important, for the rather simple fact that US consumption growth isn’t the single locomotive for the world economy any more. And if we should believe economists, the US consumer will not regain this position in the foreseeable future. They will be too busy paying down debt and saving for retirement. Hardly any economist will disagree with this.

However, what seems to be underestimated from time to time are the monetary linkages throughout the world, in which US monetary policy is as dominant as ever. Although US economic leadership is diminishing, US capital markets are still the most liquid and the US dollar remains the most widely used currency for international trade; credit origination; and financial transactions. True, the share of international trade in yuan is rising, while central banks around the world diversified some of their foreign currency reserves from dollars to euro’s, but the US dollar still has an comfortable number 1 position.

This means US monetary policy has a bigger impact on world markets than its shrinking relative weight in world GDP would suggest. US dollar (soft) pegs by several emerging market economies are adding to the global influence of US monetary policy. To maintain the dollar peg while avoiding huge amount of ‘hot money’ inflows, these countries have to copy the loose monetary policy of the Fed. 

In the old normal, when the US (consumer) economy was the locomotive of world economic growth, the ‘standard’ cycli could be characterized as follows. The US Federal Reserve loosened its monetary policy, which made it more attractive for US consumers to save less and borrow more (notably to buy residential property). Additionally, consumers felt more prosperous as property prices were rising (more than 60% of US households own property). The result was a steadily declining savings rate and a rising share of consumption in total US GDP to well above 70%.

This asset price and credit driven growth in consumption demand was increasingly satisfied by higher imports from notably Asia, which in turn became increasingly dependent on the US consumer. Not surprisingly, economic policy in emerging Asia became more and more directed towards the US growth cycle (including the currency peg with the dollar). Although many economists warned that the rising current account deficits and skyrocketing credit growth in the US were leading to unsustainable bubbles, policy makers in both the US and emerging Asia were happy to proceed and harvest the short term gains.

The big wake up call came with the credit crisis. US consumption declined, leaving emerging Asia heavily exposed to a recession and social instability. China acted promptly, and announced a stimulus plan worth 4 trillion yuan, or nearly 15% of GDP, to be spread over just two years. With the help of the positive effects of financial and structural economic reforms after the Asian crisis, the stimulus package is a great success in terms of growth. China is growing 10% or more per year, with most other Asian countries growing 5% or more. Although a recovery in exports to the US and Europe has contributed to the stunning growth performance, there is a broad based recognition among economists that Emerging Asia has discovered an internal growth engine for years to come.

For the world economy as a whole, this is a positive development. It reduces the dependence on a credit fueled US consumption boom and it opens a window of opportunity to rebalance world trade as consumption driven growth in Asia increases the demand for Western products and services. With the growing importance of Asian economies in the world economy, the monetary policy framework in many Emerging Asian countries is lagging sorely, as it is still designed to accommodate a US led world growth cycle. There is some ‘decoupling’, with the Chinese yuan appreciating slowly against the dollar but overall Asian central banks pursue a too loose monetary policy just to prevent a market driven adjustment of their currencies.

This means US monetary policy is indirectly turbo charging growth in these emerging markets through basically two channels. The first is via interest rates of most emerging countries, which are are set too low – below inflation – relatively to their growth (potential). The second channel is that high growth rates in these countries attract money inflow from the slow growing Western economies. Specifically, investors will continue to benefit by borrowing in dollars and invest the proceeds in these countries, or buy stocks and/or commodities with it. With near zero percent interest rate, the cost of carry is small and in many cases, dividend yield is higher than the borrowing rate.

Just as the yen was the preferred funding currency of these carry trades before the crisis, the US dollar is rapidly becoming the preferred funding currency. But nowadays with a much bigger impact on world markets as it is the reserve currency of the world.

The implication is that as long as the US currency plays a more dominant role than the size and the dynamic of the US economy justifies, a loose US monetary policy is poised to turbo charge asset prices, including commodity prices, and inflation for some time to come.

There will be periods of strong countertrend moves, especially when commodity prices and long term interest rates are rising to growth limiting levels, growth and asset prices will then start to decline and carry trades will be unwound, leading to a stronger dollar. However, declining asset prices will intensify deflation fears in the US. Why? The US economy is likely to struggle for some years to come to deflate its credit (both private and public) and asset prices bubbles, which is deflationary and growth constraining. To fight the renewed deflationary threat, the Fed will likely embark on another round of quantitative easing in order to push up (domestic) asset prices. However, the emerging economies, with their more attractive growth prospects, and commodity markets will then again attract a major part of the extra dollars created by the Fed.

In the long run, this is a positive for commodity and stock prices, while negative for the US dollar and bonds. However, in between there will be powerful countertrend movements when carry trades are unwound and deflationary fears are increasing. In our view, we are approaching one of these powerful countertrends fast.

Maarten Spek, analyst financial markets at ECRResearch.com

ECR Research (www.ecrresearch.com) is one of Europe’s leading independent macroeconomic research institutes focusing on the main currency and interest rate markets. The ECR reports reach a worldwide audience of sophisticated investors and treasurers and CFO’s within corporations and financial institutions. ECR offers a wide range of research products which are online accessible and updated on a weekly basis.

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