Fed up - almost out of excuses not to hike


Jan Dehn, head of Research at Ashmore, looks at the news that China’s RMB is set for inclusion in the SDR, the IMF’s reserve currency basket, this month.

In other markets, the reaction to rumours that Henrique Meirelles could replace Finance Minister Joaquim Levy in Brazil shows that President Dilma Rousseff still has options.

In the global backdrop it is déjà vu time; the market is testing the Fed’s commitment to its declared intention of hiking rates in December by pushing down stocks and pushing up the US dollar.

Rapid pace of reform for China
Never underestimate the pace of reform in China. IMF chief Christine Lagarde and her staff last week declared that they have approved the Renminbi (RMB) for inclusion in the Fund’s basket of reserve currencies, the Special Drawing Right (SDR).

Formal inclusion will likely take place at a meeting on 30 November 2015. In our view, the RMB is expected to be given a weight of approximately 13% in the basket.

China has moved quickly to address the remaining technical issues identified by the IMF in July of this year, including adjusting the overnight fixing of the currency to the spot rate (a move that was wrongly interpreted as a deliberate devaluation by many analysts).

The RMB’s ascent will likely be far more rapid than the speed at which China will catch up with per capita GDP in the Western world. Some 97% of the world’s FX reserves are presently invested in just four currencies (USD, EUR, JPY and GBP).

All four central banks that issue these currencies are currently abusing their reserve currency status by printing money through Quantitative Easing (QE) programs, with much of the printing happening because governments cannot pass the reforms required to achieve supply-side led growth.

QE policies will eventually lead to inflation and/or currency debasement, which in turn will result in an acute shortage of global reserve currencies with integrity. This bodes well for the rapid adoption of the RMB by central banks.

In our view, all investors should have a China strategy, in the way most institutional investors have a US strategy. China’s RMB is ultimately destined to replace the US dollar as the world’s primary reserve currency, while China’s central government bond market will become the world’s primary reference market for fixed income. This prediction is simply the inevitable consequence of China’s size – China’s population is more than four times larger than that of the United States.

If per capita GDP grows at the average pace sustained between 2011 and 2015 in both the US and China – i.e. since US QE policies began – then China’s per capita GDP will overtake that of the United States by 2043.

Rumours circulating in Brazil
Rumours are swirling that Finance Minister Joaquim Levy may be replaced by former central bank president Henrique Meirelles. The rumours were denied by President Dilma Rousseff. However, the market reaction was telling. Brazilian markets rallied strongly intra-week in response to the news.

This information is valuable; it shows that (a) Levy’s effectiveness has declined to the point where his departure would not adversely affect the outlook for reforms and (b) Meirelles may be more effective in moving the reform agenda forward. Meanwhile, retail sales declined 0.5% in September from the previous month.

This was not as bad as expected (-0.9% mom). Retail sales are now 11.5% lower than in the same month last year.

Déjà vu
November is beginning to look like August. The Treasury market has priced in a 70% probability of a Fed hike next month, but FX and stock markets seem bent on allowing their current momentum to carry further, perhaps in a bid to test the conviction of the Fed behind its stated objective of raising rates in December.

Risk aversion – some of it in the form of lower US stock prices – certainly took hold last week, while the US dollar has staged a recovery.

The latter in turn pushed down oil prices (aided by higher than expected inventories). This means that the euphoria following the recent strong payroll number has already given way to gloom following weak retail sales data. But the data may ultimately be of secondary importance right now; the stock market is well aware that the Fed is bound to honour a de facto third mandate to keep asset prices high after years of QE.

If so, it is conceivable that concerted pressure on the Fed via a higher US dollar and lower stock prices could potentially force the Fed to U-turn on hikes in December, just like what happened in September. All in all, this fact provides a bearish global backdrop for EM asset prices as we enter the last month before the scheduled 16 December Fed meeting.