Why Fed Strategy is Backfiring


MISTAKE? - Emerging markets have come back under pressure post last week's FOMC rate decision. This is a development that needs to be watched closely as it's something the Fed was clearly concerned about. It seems, in the early week, the US Dollar is regaining momentum after both Fed Bullard and Lockhart offset last week's FOMC dovishness with hawkish comments, as both expected to see a liftoff in 2015. Of course, the reality of an impending rate hike in the US is something that puts a strain on yield differentials outside of the US, with the higher yielding emerging market currencies the most exposed. But as much as the Fed would like to alleviate such external risk to the global economy, it needs to be careful it doesn't shoot itself in the foot. This point has become that much clearer in the aftermath of last week's surprisingly dovish FOMC rate decision, when risk markets were unable to rally on what should have been a well received piece of event risk. And so, the Fed needs to understand that at this point, holding off on a rate hike because the emerging markets are under pressure, may not be the best move.

RUN THE COURSE - Probably better to go ahead with a small 25bp rate hike, signal the US economy is in the throws of a healthy recovery and try and bolster global sentiment that way. The reaction in stock markets since last Thursday could very well get the Fed thinking more about its strategy and could result in a decision to finally move forward with the first rate rise since 2006. At a certain point, you just can't avoid things that need to play their course. We had a major crisis several years back and we have done whatever we can to slow the negative impact from the crisis. But this doesn't mean there won't be fallout and we need to be reminded of this fact. Of course there is downside risk to emerging markets and risk assets when the Fed starts to raise rates. At the same time, I'm not convinced these markets are better off with the Fed continuing to delay liftoff. Bottom line, I think we will see the Fed reconsider its stance and indeed move ahead with a rate hike before the year is out. From a markets standpoint, this will result in another wave of US Dollar demand, more record low weakness in emerging markets and more downside pressure in stocks. But this all needs to happen and will be very healthy. Sometimes recovery is painful, but there just isn't any way around it.

The Fed could be reconsidering its strategy post last week's decision. Via @joelkruger

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