by Bernadette Grant-Smit


Can a strengthening dollar protect against multiple Fed interest rate hikes?


With the US Federal Reserve Bank (Fed) raising the target federal funds rate by a quarter of a percentage point to between 0.5% and 0.75% in December last year, (marking the first time the Fed has raised rates since December 2015 and only the second time in a decade), this is unlikely to be as damaging for local markets as previously feared. In addition, the threat of more aggressive hiking by the Fed next year would be moderated by a stronger dollar.

This is according to Peter Brooke, Manager of the Old Mutual Flexible Fund at Old Mutual Investment Group, who says this is only the second rate hike since the 2008 recession. However, as indicated by a very strong dollar and global bond yields trending up, this has already been largely priced into the market and should therefore result in very minor market impacts.

“Following the recent hike, our economists forecast another 50 basis points of hikes in 2017, taking US interest rates up to 1.25%.” This is in line with consensus, but Brooke says the risk is to the upside as any Trump inspired fiscal package will add to growth.

A major influence will be the strength of the US currency. “The stronger the dollar, the less the need to hike interest rates further. The dollar has strengthened extensively already and, if sustained, this will act as a drag to the US economy.

“One of the biggest risks for markets is a super strong US dollar.

For example, if the Fed is more aggressive than anticipated, this would result in further strengthening of the dollar. Similarly, if the Chinese economy begins to slow down following the winding down of their stimulus efforts, the dollar would strengthen. Finally, we have a massive calendar of elections in the Eurozone, which have the potential to destabilise the Euro, boosting the US dollar. Therefore, in terms of balancing risks, the strength of the dollar will have a significant influence on Fed policy over the foreseeable future. I think it is safe to say that a strong dollar will be protection from further rate hikes.”

Looking out to the medium term, Brooke points out that there has been a global shift whereby monetary policy has essentially hit its limit. “There is definitely a shift towards fiscal stimulus for a number of reasons. Firstly, interest rates are very low, allowing governments to borrow at a cheaper rate. Secondly, there is a shift towards populism, which means people are requiring more jobs and further local development, and finally, the entire financial services industry doesn’t want negative nominal rates, creating the perfect situation for fiscal stimulus.

“The speed and size of fiscal stimulus in the US will, however, be up for debate because this is not typical republican policy and it may be easier for stimulus to take the form of tax cuts,” he adds.

Regardless, Brooke believes that either option would be good for growth and capital spend in America, ultimately driving global growth. “In terms of expected returns, there is a strong theme of reflation, linked to the shift towards fiscal policy. With Chinese producer price inflation (PPI) hitting its highest level in five years, we’re seeing more inflation coming through, but do not expect runaway inflation.”

Brooke concludes on how this outlook affects his team’s global equity positioning. “The current global outlook favours equity over bonds, which is exactly the way we’ve been positioned, with a strong preference for value over growth and opting for cyclical over defensive counters.”

According to Tinyiko Ngwenya’s, Economist at Old Mutual Investment Group, the most likely impact that the Fed rate hike will have is on capital flow. Investors always seek higher returns for their portfolios and are therefore more inclined to move money to countries that yield better returns. The prospect of higher US yields will result in foreign investors moving their rand based investments to the US causing the ZAR to weaken in relation to the US dollar, she says.

“At the moment, the market, along with ourselves, has priced in 2 X 25bps hikes for 2017, a little less than the 3 X 25bps hikes that the Fed expects. So if the Fed were to hike more aggressively than the market suggests, then we would see the ZAR depreciate along with other emerging market currencies. A weaker ZAR will result in a more cautious Reserve Bank. Although we still believe that the Reserve Bank will cut rates at least twice this year, more aggressive rate hikes in the US will cause the SARB to be wary of moving too soon. The impact of the above however will be muted where the Fed raises rates in an environment where the rest of the global economy is looking better.”

Ngwenya told Opportunity, looking at trade and investment in the South African landscape, a weaker rand is positive for our trade balance in that exports pick up as South African goods become more competitive globally.

“The trade balance is just one component of the current account balance, and any uplift in the trade balance will support a current account correction which is positive for our investment grade rating. This offers an even greater advantage where the prices of key exports such as iron ore and coal have stabilised, although the risk of a stronger rand remains an overhang for commodity prices.

“A stronger dollar is negative for emerging market currencies, more especially commodity exporting countries as a stronger dollar implies weaker commodity prices.

“Countries with high foreign debt will especially be vulnerable as a weaker currency makes it more expensive for those countries to repay their dollar denominated debt. South Africa is fortunate in that it has low dollar debt levels (around less than 10% of total debt) which helps guard government finances from a weaker rand,” says Ngwenya.

As for the impact of a stronger American dollar on South African markets, outflows to US Treasuries will result in higher yields for South African bonds—and a weaker rand may however benefit rand hedge stocks, which will indeed value from the translation of their offshore earnings.

Which industries are likely to benefit/suffer from such an interest rate hike? “A stronger dollar implies weaker commodity prices where demand and supply forces aren’t strong enough to sustain higher levels which impacts mining companies who will face further pressure on their margins.

“The mining industry has been a drag on the economy, falling -18.1% in the first quarter of last year, recovery mildly along the year.

“This week’s mining production number however points to a weak end to 2016. Car exports are likely to benefit from a weaker rand just as they had in 2016,” Ngwenya concludes.

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