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Can’t Take My Eyes Off The Fed

Anything concerning the US Federal Reserve is currently the rage. As it stands, there will be rate cuts this year, and the timing of the first cut is currently the focus of the public’s attention.

Shifts in these expectations have caused the US Dollar to move either way, and this has had knock-on effects on ringgit movements.

For example, the ringgit saw gains after the dollar fell in early March due to weaker services purchasing managers index (PMI), which accelerated cut expectations.

Then, the ringgit weakened anew after the dollar turned higher in reaction to stubbornly high United States (US) inflation, reducing rate cut expectations. The US economic trajectory remains key, but other factors can intervene to shift the Fed’s focus.

I only have eyes on inflation

In its recent decision, the Federal Open Market Committee (FOMC) kept its policy rate steady, maintaining a range of 5.25 per cent to 5.50 per cent.

The committee judged it would be appropriate to cut the rate with greater confidence that inflation is moving sustainably towards 2 per cent.

It underlined its commitment to returning inflation to the 2 per cent objective and remains highly attentive to inflation risks.

During the press conference, Fed chair Powell stated that inflation is still too high and that the progress in bringing it down is not assured.

He added that the committee is prepared to maintain the current target range longer if appropriate. Shelter costs are currently driving inflation, excluding this, consumer price index (CPI) was only up 1.8 per cent over the year. While rents are expected to decline, it may not be fast enough.

Perhaps an eye on growth

Chair Powell also said a policy response would be warranted should the labour market unexpectedly weaken. The unemployment rate remains near decade lows, and personal incomes continue to improve, rising 1.0 per cent in January from an average of 0.3 per cent.

US fourth-quarter gross domestic product (GDP) was recently revised by 0.2 per cent to 3.4 per cent, driven by consumer spending and fixed investments.

Forecasters are not expecting a significant improvement in growth dynamics, but more crucially, they are not expecting a large drop in activity either. Equity markets continue to trade at record highs, and bond yields are largely rangebound.

It seems like the US economy will have to slow down more significantly for downside pressure on inflation to truly exert itself.

An eye for an eye

Beyond the US economy, a significant jump in geopolitical violence can also shift Fed expectations.

This, however, looks unlikely given that the most significant market reaction to geopolitical tensions occurred in 2013 when Russia invaded Crimea.

Since then, geopolitical conflicts have flown under the market’s radar as major nations pull away from actively participating in direct military action.

Conflicts in Africa, domestic troubles in South America, the war in Yemen, North Korean missile firing, the Ukraine war and the war in Gaza have not caused much shift in policy expectations.

China’s attack on Taiwan, however, has the potential to disrupt global trade and draw other nations into the conflict, necessitating a policy response.

Others eye cutting rates

Other central banks are also in the mix. European growth is anemic and is screaming for some rate cuts. The European Central Bank (ECB) is, however, progressing cautiously, waiting for a sustainable move lower in inflation.

The Bank of Japan has raised its policy rate from 0 per cent to 0.1 per cent and ended its yield curve control. It, however, will continue to buy bonds at the same amount as before, essentially maintaining a very easy policy.

Generally, all central banks, with the exception of Japan, have reached a rate plateau, and the next step is to lower them. The country cutting rates the fastest will likely see its currency decline faster than the rest.

Again, the Fed sets the tone here given that the ECB moves like an overloaded cargo ship and the other central banks are relatively small in their influence over global markets.

Cast your eyes elsewhere to find little there

What of other nations’ fortunes? Of the economies out there, China looms large over Asia. A collapse there can increase the Dollar given its significantly negative repercussions to Asia and Oceania.

In the past, the Fed has shown little reaction to country-specific economic development, but China’s oversized influence in Asia might warrant some action.

Beyond China, there is little concern over significant economic disruptions in other major countries, which, therefore, is unlikely to influence the Fed over the intermediate term. Other concerns, such as a pandemic, domestic political crisis, financial crisis, or policy missteps, have had little influence on markets recently.

Inflation in the bull’s eye

We then arrive at the beginning, where the US economy will set the tone. The country’s growth dynamics remain, and inflation is relatively high. Considering the Fed’s focus on inflation, current projections of 3 rate cuts might be a little too much.

The Fed can possibly push its rate cuts further out into 2024 or temper expectations of further rate cuts following the first move. These adjustments will underline dollar strength and keep the ringgit weak. This then might necessitate the local Central Bank to act.

Profits in the eye of the beholder

Bank Negara will be justified in raising rates should the persistently weak Ringgit fuels inflation. Based on initial impressions, this would have a negative effect on local equity markets.

In other words, the rate hike can help cover the US yield gap and counter dollar pressure. This can also aid the ringgit’s gains against other major currencies and regional peers.

Better ringgit expectations coupled with attractive domestic valuations can drive foreign flows into domestic equity and bond markets.

Bond yields are likely kept anchored by strong domestic demand and from Bank Negara addressing inflation concerns.

Domestic assets then look attractive either way. Despite what is happening over there, the knock-on effects look positive here.

Julian Suresh Sundaram
Independent Economist

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