The Fed has also been adamant in its statements about the easy money policy and reaffirmed its commitment to buy assets and free up liquidity to support markets. But what got a lot of people thinking is that on key macro variables, if this is a boom that the United States has entered, then policy reversals have to happen sooner rather than later. But why then there are no clear indications of a likely policy change.
At the recent FOMC meeting, the potential timing of the first rate hike was set at 2023 instead of 2024 which had been decided earlier. In fact, some board members were of the view that the first hike could take place as early as 2022. This is a big sign that rates may start to rise sooner than expected and that markets should prepare for it. If we remember, there was a statement by the Secretary of the Treasury herself that higher interest rates are good for the US economy.
Lesser-known Fed officials have also made statements about the need to change course if prices rise. On top of all this, there were major reports that said the Fed is gradually preparing the markets for less liquidity support over time.
Despite all of this, there remains a veil of uncertainty over the next US interest rate move and timing. Interestingly, the ten-year treasury that was only a stone’s throw from the 2% mark has collapsed to 1.45% / A every time it goes up to 1.50%. , an invisible factor brings it down again to 1.45%. It might also reflect the idea that there is still time before Fed policy begins to reverse.
But the crux of the matter is that the Fed shouldn’t suddenly change the tone of the conversation and act quickly after a prolonged period of political suspense. If this actually happens, it can have consequences for a lot of things.
The tapering is shrinking, the effective liquidity available on the markets. Part of the rise in asset prices, apart from the market premium and asset-specific factors, is driven by the liquidity factor. Therefore, the first victim will be asset prices and a moderation of these prices can be expected. The higher yield of the US dollar will allow it to remain strong against other major currencies and even more so against emerging market currencies.
These are the movements of assets that determine the movements of currencies all the time. Emerging market currencies might not be spared this time either, as the flow of funds to the US and Europe could be greater than before. These are some of the lessons we could safely learn from the last time we had the cash flow crunch. A stronger dollar, weaker commodity prices, and relatively cheaper currencies could redefine the investment landscape over time.
One thing we could take some comfort from is that the Fed may start to prepare the markets more actively before any action is taken and that in the change from current circumstances hopefully the same will be better planned. This means that the markets and the Fed would move on parallel tracks although the pace could be clearly different. At the same time, it is important to be diligent about this so as not to fall prey to the consequences of possible political procrastination by the Fed.
(By Dr Joseph Thomas, Director of Research, Emkay Wealth Management. Opinions are his)