2016 has been anything but expected. After the Fed raised interest rates by a whopping 25 basis points in December 2015, one would have thought that it provided clarity in terms of US economic health and the state of domestic demand. The first few months of 2016 were up there with the highest periods of volatility the market has seen in recent years, even amid the depths of the Greek debt crisis. In China, the authorities removed the ban that prevented large-scale asset selling in 2015, creating fears the market would continue falling as investors sought to offload any Chinese holdings.
The Mood Drivers
Expectations of Fed rate hikes, coupled with increasing political upsets, caused a risk-off mood dampening animal spirits, even amid a reasonable earnings season in Q1/ Q2 of this year. Brexit was a shock to the financial system with the currency taking the main strain, adding to fears from the large trade deficit for future foreign direct investment. In Europe, the ECB expressed concerns for the politicians to get their act together and bang heads to generate a fiscal plan to extract the Eurozone from the messy quagmire they find themselves in. QE will continue until March 2017, with a reasonable expectation of it increasing until December 2017. They will then reassess and if there is any more stuff left, buy more.
Looking ahead, because US elections are taking place in November, the Fed will definitely hold fire at least until December. Although US data has held up reasonably well, one would not be surprised to see another delay, irrespective of who takes the hot seat in the White House.
Looking even further ahead, spotting the next crisis will be crucial. Crises often occur due to the build-up of excessive leverage, asset price bubbles or mass dollar strength, as was the case in the Asian crisis of 97/98.
Will the dollar cause havoc to create another crisis? It is unlikely because the terminal level of the Fed funds rate will be much lower than in the past. Furthermore, with a hike of 25 basis points seemingly every 12 months, the euro could actually go up before the dollar does.
Canadian household debt is at an astronomical 294% of GDP. It is quite bizarre how this has not already slowed consumer spending and thus bank lending.
In Eastern Europe, Turkey, in particular, has a large amount of foreign currency debt. No wonder the Turkish central bank is concerned, but not with those rather domestic demand dynamics. The problem is that lowering rates to stimulate domestic demand comes at the price of a weaker currency. A lower currency makes the external debt obligations higher and risks destabilising government finances. That said, in a recent interview, president Erdogan outlined that lower interest rates help curb inflation. He then went on to say: “those who expected the currency to crash, didn’t get the result they wanted”.
What will determine Turkey’s fate will be the decisions made by the FOMC. Should inflation keep rising in the US, the Fed will be inclined to keep it under wraps by gradually increasing the reference rate. The dollar will rise along with Turkey’s real external currency debt. When asked about the country’s downgrade by the ratings agencies, Erdogan replied: “I don’t care.”
If he cares about the wellbeing of the Turkish economy, he should care about it being labelled “junk status.” Sit tight for a Turkish tantrum in 2017.