The Fed-Asia Connection

As our Chief Investment Strategist Martin Hutchinson pointed out in the August issue of Pacific Wealth, a minor currency war has broken out across much of the Asia-Pacific region. We’re probably all well acquainted with China’s recent moves, but Vietnam has actually devalued its currency three times so far this year and others are expected to join in. While the Chinese devaluation to support its flagging exports may have been the spark, our own Fed has been providing a lot of the tinder.

As we all know, the markets hate uncertainty and to say it is increasingly uncertain when the Fed will raise interest rates is an understatement. While the Fed had seemed fairly consistent in signaling that a September hike shouldn’t come as a shock, that messaging shifted.

Last week, New York Fed President William Dudley seemed to rule out a hike when he said the recent turmoil increases the downside risks to the U.S. economy. But at the recent Jackson Hole conference, Fed Vice Chairman Stanley Fischer hinted that a hike might not actually be off the table. That basically leaves in the markets to choose between heads or tails.

So why does the Fed’s interest rate policy matter to Asian-Pacific economies? A U.S. rate hike would lead to a stronger dollar, which would then lure money away from those economies and back into the U.S. Largely thanks to Fischer’s comments last week, there were sizable outflows from most asset classes in the region, with $4.2 billion flowing out of debt funds alone. That was the biggest weekly drop in the taper tantrum in 2013 but, unlike that tantrum, this one was largely just on speculation.

That shifting capital and the resulting stronger dollar puts pressure on currencies that are essentially pegged to the dollar – like China’s yuan.  And that could potentially spark another round of devaluations. Rinse, wash and repeat.

In fact, a lot of folks in Asia haven’t been shy about calling the Fed out on this very point. Indonesia’s finance minister blamed the rate uncertainty for the recent swings, while a Chinese central bank official actually said it was hoped the Fed would delay any interest rate increase. India’s finance minister flat out said it would be nice if the Fed would actually coordinate hikes with other central banks.

The whole situation does sort of leave Janet Yellen between a rock and a hard place. If inflation does pick up over the next few months, as Fischer said he expected, the Fed is better off staying ahead of it. But if it does bump up short-term rates, we’re sure to see more market volatility.

Since the official decision isn’t due for two more weeks, I wouldn’t really hold my breath on things calming down. Ironically enough, while a delay in hiking would likely buy us at least a couple of weeks of calm, it won’t end the jitters since there are still at least two more opportunities for a hike this year. Frankly, the only way the markets will have any certainty is if the Fed were to go ahead and make a move, but that might not produce the desired outcome of a calmer market either.

While interest rates aren’t the only variable in the equation, there are going to be swings until the Fed makes a move.