On March 23, US Federal Reserve policymakers said they were prepared to act aggressively to bring down unacceptably high inflation, including a possible half-percentage-point interest rate hike, or even more, at its next meeting in May. The Fed had previously forecast that rates could rise to 1.9% or higher by the end of the year.
The messaging came barely a week after the Fed's move to raise interest rates by 25 basis points on March 16 - the first since 2018, as the US posted the highest inflation in decades.
Investors are pricing in up to seven interest rate hikes for 2022, but how will the rate hikes affect Asia's capital markets? Fixed income and equity experts in Asia spoke to AsianInvestor this week about what these structural shifts may mean for investors in the region.
The responses have been edited for clarity and brevity.
Brian Nick, Chief Investment Strategist
As the central bank for the world’s largest economy – and its largest importer – the Fed’s monetary policy has global implications. Its expectations for a more aggressive path of interest rate increases has helped to push up the US dollar against most other currencies while also tightening US and global financial conditions. This will lead to somewhat slower domestic US growth via weaker US consumer and business sectors, which will affect export-sensitive capital markets in Asia.
Several Asian central banks – China is a notable exception – have also started to raise interest rates, but the Fed’s planned path of hikes comes sooner and is set to be steeper, meaning virtually all Asian currencies are down year to date vs. the dollar.
Expectations for tighter monetary policy have hit high-growth companies more than others, leading technology shares to underperform and contributing to similar underperformance in Asian markets with large tech sectors.
Lastly, as US interest rates rise and the US dollar strengthens, debt issued in US dollars will become more expensive to finance, which could hurt Asian economies that issue large amounts of debt in dollars.
Andrew Zurawski, Associate Director, Investments Asia
Willis Towers Watson
The Fed is projecting sizeable increases in its policy rate over the next two years. Interest rates in Asian economies are unlikely to rise as quickly – in fact, in China we are expecting more easing in policy rates in coming months. These conditions are usually supportive of strength in the US dollar, and the higher rates could also see a rotation back into US government bonds from Asian and Chinese bonds as spreads narrow.
Past US tightening cycles have sometimes been associated with stress in Asian financial markets. In this cycle, we generally see risks for Asian economies as lower than previous episodes due to several mitigating factors such as solid economic fundamentals and a lower share of debt denominated in US dollars, although higher rates could mean pockets of stress for some of this debt. Inflation has also been much lower in Asian economies than the US and Eurozone, providing more room for central banks in the region to support growth. Lower policy rates should be supportive of risky assets such as equities, as should the recent pivot by Chinese authorities to be more supportive of financial markets.
Mary Nicola, Global Multi-Asset Portfolio Manager
For Asia, economic growth should be robust enough to withstand more tightening of financial conditions, however quantitative tightening can be a significant headwind for markets. Asia and other markets have benefited from ultra-loose monetary policy from global central banks.
On the flip side, Chinese policymakers appear to be responding to their growth undershoot through policy easing, albeit in baby steps. We expect this stimulus to target higher value-added manufacturing and climate priorities. That said we do see EM (emerging market) equity markets benefiting from this policy stimulus. While the US is tightening, China's policy of loosening should be supportive for EM. Meanwhile, the key focus over the next 9-18 months will be on inflation and the impact of the rise in commodity prices. Within Asia, higher oil prices may cause large commodity importers like India to struggle with higher inflation, while commodity exporters like Indonesia may benefit from improving terms of trade.
Brad Gibson, Co-Head – Asia Pacific Fixed Income
Asia’s bond and currency markets will not be completely immune from US rate hikes and the withdrawal of emergency levels of USD liquidity splashed around to cushion the blow of Covid lockdowns. While each market will be different in terms of precise timing, we can expect most central banks in the region to follow the Fed's move, if they haven’t already.
Given the milder overall inflationary backdrop in Asia compared to the US and the ongoing battle to tackle Covid flare ups, we see a mild tightening cycle commencing in Asia. This is likely to see Asian bond markets continue to outperform other developed or emerging regions. The economic diversity within the region in terms of exposure to commodities, trade, tourism, global supply chains etc creates opportunities for investors to position within Asia to capture a range of potential market outcomes.
One glaring exception to this monetary tightening theme in 2022 will be China where the potential for further monetary easing will dominate that market. We have already seen China government bonds strongly outperform US and European bond markets in recent months and there are good reasons to expect this trend to continue. Inflation-adjusted yields remain relatively attractive.
Carol Lye, Associate Portfolio Manager & Senior Research Analyst
Approaching the first Fed rate hike in March, Asian fixed income markets had been diverging as inflation is less entrenched here and China’s easing has been a support. In addition, the focus of the Asian high yield market is still on the somewhat broken China property sector. Going forward, the divergence between China and US rates will continue as China eases. This will result in a lower US-China rate differential.
Given the strength of the CFETS (China Foreign Exchange Trade System) basket, it would not be surprising if the Chinese RMB weakened somewhat from here. The low yielders in Asia such as South Korea, Singapore and Thailand are likely to continue seeing yields rise alongside global yields as the Fed hikes rates. In contrast, the high yielders such as Indonesia and India may need to start hiking rates alongside the Fed to keep the buffer of their rate differentials and prevent weakness in their currencies.
Silvia Dall Angelo, Senior Economist
The Fed tightening cycle – which could be quite aggressive this year, judging by the Fed's recent communications – poses issues for Asian capital markets in an already challenging context for Asian economies this year. Dovish Fed policies meant that financial conditions were easy for emerging economies in 2020 and most of 2021, as international capital markets were particularly accessible to EM borrowers. Fed tightening would lead to risk aversion and potential capital outflows from EMs. Higher US rates and a rising differential with local rates – Asian central banks are likely to hike their policy rates more gradually given the more benign inflation picture they are facing as they risk fuelling weakness in local Asian FX and broader financial market volatility.
The strengthening of the US dollar that is likely to accompany Fed tightening will result in tightening financial conditions for Asian developing economies that rely on dollar financing. In general, the environment for Asian economies looks challenging in light of weaker global demand and declining trade growth, an ongoing slowdown in China, stimulus withdrawal in the US and, more recently, the escalation of geopolitical risk. Ultimately, slower domestic economic growth would be detrimental for Asian capital markets.