Dollar Strength Based on Interest Rate Divergence
The Federal Reserve (the “Fed”) is on the verge of hiking American benchmark interest rates for the first time since June 2006. The central bank was forced to cut the Fed funds rate to an all-time low of 0.25 percent following the credit crisis of 2008. Since then, the U.S. economy has steadily climbed out of recession, prompting the central bank to announce in the summer of 2013 that it would end its quantitative easing program.
The Fed started scaling back its bond-buying program under Chair Ben Bernanke and later under Chair Janet Yellen who took over the central bank in early 2014. Chair Yellen has not been a straightforward communicator compared to her predecessor, making investors unsure of when this key decision from the central bank will occur.
U.S. Economy Giving Mixed Signals to Central Bank
The Fed initially tied the timing of the first rate hike to employment indicators. The non-farm payroll report (NFP) is the most influential indicator on the number of added jobs and the unemployment rate in the American economy. The U.S. recovery, while showing signs of improvement based on the headline figures from the NFP report, has not been as strong as many economists at the Fed would have liked. Albeit, the employment rate has recovered to pre-crisis levels and the number of jobs created look healthy as standalone data points.
Looking in depth at the NFP, the data is mixed at best. Wages in the U.S. are not growing and although the number of jobs are increasing, they are part-time or at lower wages. The Fed has said that the labour force participation rate is lower than it should be which means Americans are leaving the workforce, giving up on seeking employment and are no longer being counted as unemployed, according to the reported labour statistics.
U.S. Dollar Strength Subject to Fed Rate Hike
The U.S. dollar has been shaken as the Fed rate hike has been repeatedly pushed back this year. The probability of a September rate hike is now 25 percent, according to the Chicago Mercantile Exchange’s Fed Watch tool, based on the 30-Day Fed Fund futures prices. Industry experts have highlighted December (at 42.9 percent) and January (at 42.5 percent) as more likely points in time for this macro-event, which could mean a further setback for the U.S. dollar as it will lose some of its strength based on a foretold rate hike that has failed to materialise.
Emerging Markets Have Evolved
Not all emerging markets are equal, and in some cases past adversities have helped to shape and strengthen the foundations of many emerging market nations. The crisis of 1994 in Latin America and the Asian crisis in 1997 served as a trial by fire, which changed the fate of the economies caught in the firestorm. The global credit crisis that started in 2008 pulled major economies into recession but also highlighted the resilience of emerging markets, as their growth was the main engine of global recovery during those dark times.
Europe and Japan are currently struggling to escape deflationary environments. The U.S. and the United Kingdom are the two major driving forces of the developed world; against this backdrop there are good investment opportunities in emerging nations that take advantage of factors such as:
- Low Commodity Prices
Oil production continues to outpace demand as the OPEC has kept production unchanged at record levels. The resulting glut in crude has driven prices to a decade’s low and reduced inflationary prices in nations like India that are net importers of the commodity. The Iran nuclear deal will reintroduce the Middle East nation to the global market and a rise in production is anticipated. Goldman Sachs has forecasted the price of oil could hit $20 per barrel a price not seen since 2002.
- Gradual Recovery in Global Trade
The Trans-Pacific Partnership of 12 nations will represent nearly 40 per cent of the world’s gross domestic product and with a healthy balance of developed and emerging nations this trade agreement will open markets and promote trade across the world. The U.S., Japan, Canada and Australia represent the developed world, while Mexico, Malaysia, Singapore, Chile, Peru, New Zealand, Vietnam and Brunei will see their growth boosted with the decrease of tariffs between the partnership nations.
- Internal Demand and Structural Reforms
Emerging markets have taken up a crucial role in the global economy. The obstacles faced by developed economies still remain and investors can now look to emerging market countries as the new frontrunners. Nations like China that have begun their transition from a service-driven economy, to a more consumption-based economy are well positioned to continue growing at a strong and sustainable pace. Furthermore, several emerging market countries, most notably India, are currently undertaking reforms that will modernize their major cities. Development in these states will improve productivity and the overall competitiveness of the emerging markets.