The Fed made one thing very clear on Thursday after it decided to leave its interest rates unchanged: short term interest rates in the US will stay lower for longer than previously forecast. The equity markets responded favourably to the news for about an hour and then changed their collective mind. A sense that the Fed explanation – of its lack of action implied lower rates of economic growth – soon overcame what might have been a favourable influence on share prices. Other things equal, lower interest rates mean higher share prices. But other things are seldom equal when central banks react, as the market has again revealed.
While equity indexes fell away, the responses in the other sectors of the capital markets were very obviously consistent with a shallower expected rising path for short term interest rates in the US. Longer term interest rates declined quite sharply almost everywhere, including in South Africa, and the dollar lost ground against almost all other currencies, including most emerging market currencies like the rand.
Interest rates have causes as well as effects. If the cause is lower than previously forecast growth rates, the expected impact on the top line of any present value calculation – a lesser expected flow of revenue and operating profits – can outweigh the influence of a lower rate at which such profits are to be discounted. This seems to characterise recent global equity market reactions. Could the market change this initially negative interpretation of Fed policy for equity values?
We think it could – because the Fed has (surprisingly) explicitly accepted its responsibilities to the global and not only the US economy. That the Fed has recognised that the strong US economy, leading to a mighty US dollar, has left strains in its wake. The Fed reacting to these strains seems to us to improve the prospects for global economic growth by moderating some of the risks to the global economy linked to the strong dollar. Furthermore, from now on any failure of the Fed to raise rates does not imply any unexpected weakness in the US economy – rather it will be the global economy that will be the focus of attention.
The disturbances to global equity and currency markets in late August emanated from China. What the Chinese were thought to be doing and intended to do to the still undeveloped market in the renminbi rattled the markets. The threat of a competitive devaluation of the yuan, whose rate of exchange was firmly linked to the very strong dollar, would be a clear danger to the global economy.
The Japanese yen and the euro, the most important competitors and customers for China, had both devalued significantly versus the dollar and the yuan without any obvious push back from the US or China. Competitive devaluations and beggar-thy-neighbour policies did grave damage to the global economy in the 1930s by decimating the volume of international trade. All economies gain from trade, buying more from and selling more to other economies and raising their efficiencies accordingly. Any threat to global trade is a threat to growth. China was perceived to be such a threat even as the Chinese authorities were doing all they could to convince the markets that they could and would support the yuan against weakness.
The weaker dollar and a globally sensitive Fed surely diminish the risks that the Chinese will make policy errors that the rest of the world will suffer from. It takes off some of the deflationary pressure on commodities and commodity currencies. It also reduces some of the burden of dollar denominated debts incurred by emerging market companies and governments. A weaker dollar is also helpful for the reported earnings of US business with global operations. The willingness of the Fed to react to global and not only US economic developments. This enhanced sensitivity of the Fed to the state of the global economy should therefore be welcomed by shareholders everywhere.
It should also help to relax central bankers outside of the US, not least those in Pretoria, who have seemed particularly agitated by the prospect of rising rates in the US. The case for lowering short term rates in SA to promote much needed additional spending has improved – as it has improved everywhere. This is good news for shareholders