Forget Grexit. The Fed Rate Hike Is Your Bigger Worry
13 July 2015 · 4 min read
Greece has dominated the financial news for months with endless talks between the left-wing Syriza government and the institutions of the IMF, ECB and the EU. The toing and froing between the two sides, with the threat of Grexit constantly in the background, has led to ups and downs in the EURUSD and EURGBP exchange rates.
With a constant barrage of media focus on Greece and doom-mongering end-of-the-euro predictions, along with the European Central Bank’s quantitative easing programme, the strong dollar and other factors, the euro has taken quite a battering. However, there is another development on the horizon that is potentially more unsettling and volatility-inducing than the Greece saga – that of the looming US Federal Reserve interest rate hike.
This is the real potential worry for businesses with exposure to the dollar. Fed chair, Janet Yellen, recently said that there would be a rate hike “later this year.”
Potential effects of first US interest rate hike in nearly a decade
Currency traders are future-oriented, and with talk of a potential rate hike in September of this year, the US dollar index is probably already calibrated for it. Historically, during tightening periods, the greenback makes gains against the basket of currencies in the six months leading up to the first rate raise. But nobody knows how the dollar will perform after. It could appreciate, depreciate or stay constant.
Again, as history teaches us, it all depends on the scale of the rate raise and the timing. The tightening cycle of 1994 for instance caught the markets off guard and hurt all asset classes, including currencies.
Threats to the US economic recovery of a Fed rate rise
While the US economy has steadily gathered pace, out of recession now for six years, there are yet some causes for concern. Though Janet Yellen affirms that the future is bright, there is much more than meets the eye, and her rhetoric, at least in public, is not as convincing as it would appear on the surface when considering the following factors:
1. Real wages
Real wages have begun to pick up, but growth is still slow. A rate hike is not likely to be forthcoming should wage growth remain so slow. Without wage increases, many Americans would struggle to pay off an increase on the interest to the sky-high credit card debts that would come with a Fed rate hike. The US economic recovery remains tentative.
2. Effects of QE
The long-term consequences of QE are as yet unclear. The 6-year Federal Reserve programme of massively expanding the money supply in the US is credited with kick-starting the US recovery, of which there is no doubt. However, enacting this programme on such a scale is unprecedented. With some commentators labelling the recovery as artificial, we are yet to see how the US economy will perform once truly tested. US QE was stopped in Q4 of 2014. ECB QE was then kicked into gear in Spring of this year, depreciating the euro against the greenback.
ECB President Mario Draghi’s “big bazooka” of €1 trillion will affect the US economy. So really, there hasn’t been much time where the post-2008 US economy was not shaped to varying degrees by a QE programme, be it the Fed’s own QE programme, implemented by former Chair Ben Bernanke, or now a mere few months later the ECB programme which has driven down the price of the euro and done the previous work of the Fed QE programme for it: namely, injecting investor capital into US financial markets.
US exports account for 13% of GDP, so while a depreciated euro may have some effect on exporters, it will likely not be too great. At least the Fed doesn’t expect it to be worthy of much note. However, European economic recovery is essential for the US economy, and while it is recovering, the EU faces many challenges ahead, not least, more from Greece, Brexit, slow growth across the continent and recession.
3. Rate hike timing
A rate hike at the wrong time could potentially derail the US recovery. This would have a knock-on effect on the US Dollar Index, potentially strengthening GBP and EUR against the greenback. Alternatively if executed well by the Fed and the US economy reacts favourably, the dollar could see a prolonged period of consolidated strength against the basket of currencies.
What you need to know
Greece has been in the financial news too much and for too long. Other things matter too. Philippe Gelis, our CEO says, “This is a perfect example of when companies with USD exposure really need to sit up and pay attention. Sudden currency movements can wipe out profits and so they need to be prepared by staying informed and investing in an effective hedging strategy.”
What do you think? Will the upcoming Fed hike have a big say in currency movements? How are you preparing your business FX strategy to protect your profits?
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Banner photo – Day Donaldson
Body text photo – Global X