Delay in the Rate Hike: Impact beyond the US Economy

The Fed’s continued delay has repercussions for more than just the US economy and markets. Heidi Richardson explains.

While some market watchers have been speculating that the Federal Reserve (the Fed) will raise the federal funds rate at its meeting this month, the central bank is more likely to do what it did in September: nothing.

The Fed’s continued delay has repercussions for more than just the US economy and markets. I believe it’s also likely to lead to more stimulus from the European Central Bank (or ECB) and Bank of Japan (or BoJ), which may ultimately support the case for stocks in Europe and Japan.

To understand why this is the case, here’s a little primer on the typical relationship between Fed rate increases and the dollar. When the Fed raises rates, the prices of dollar-denominated assets like US Treasuries generally drop, while their yields correspondingly rise. In response, both foreign and domestic investors have tended to flock to these dollar-denominated assets, increasing demand for dollars, and leading to a stronger dollar.

Delay in the Rate Hike: Impact beyond the US Economy

Market Realist – What’s the impact of the delay in the rate hike?

In the previous tightening period between 2004 and 2006, the yield on the ten-year Treasury (IEF) rose by 120 basis points. However, this attracted foreign interest. This led to the yield on the ten-year Treasury falling by 70 basis points. After the financial crisis, yields stayed low due to the Fed’s easy money policy—including the three rounds of QE (quantitative easing).

When the Fed hikes interest rates, it attracts yield seekers away from riskier assets towards safe-haven assets like Treasuries. When safe assets’ prices fall, like Treasuries (TLT)(TLH), investors typically sell risky assets like emerging market equities (EEM) and purchase Treasuries. Now, Treasuries are available at attractive levels.

This time around, while the US Treasuries are offering much lower prices than it did in the last few tightening cycles, the yields on other developed market sovereign bonds are even lower. As a result, the foreign demand for Treasuries will remain high, even when the Fed eventually hikes rates. As funds flow to the US, the dollar (UUP) will strengthen.

Read on to find out the consequences of the Fed’s decision to hold rates on the dollar. We’ll also discuss the probable impact on monetary policy elsewhere.