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Why Janet Yellen intends to hike rates

Despite tepid growth and low inflation and what it means for SA.

JOHANNESBURG – The recent devaluation of the Chinese currency and turbulence in global markets have triggered renewed speculation about the timing of the US Federal Reserve’s rate hike.

The Fed has previously signalled that it intends to start raising rates later this year, albeit at a slow pace.

“Based on my outlook I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalising monetary policy,” Fed chair Janet Yellen said in a recent speech, providing a clear indication that she wants to raise rates.

But why would the Fed want to hike rates in an environment where growth rates are between 2% and 2.5% and inflation is barely above 0%?

STANLIB chief economist, Kevin Lings, says Yellen’s first problem is that people around the world who should be taking risk, aren’t.

“Who should be taking risk? The corporate sector. Corporates should be investing – not just in South Africa but globally. It’s a global story. The cost of capital is the lowest ever. Corporates should be using the lower cost of capital to invest, but they’re not.”

The second problem is that people who shouldn’t be taking risk, are.

Lings says fund managers are constantly seeking a better return.

A ten-year German government bond today has a yield of around 0.6%. It is challenging for fund managers who charge their clients for these very low returns, and as a result they turn elsewhere for increased returns.

“But by trying to get the increased returns they take on excessive risk.”

Countries like Rwanda and others have issued global bonds, which have been oversubscribed. In an effort to push up their yield and get a better return, some fund managers have bought these instruments.

“But ultimately you’re putting pensioners’ money into Rwanda bonds or other instruments. In other words you’re taking more risk to seek that higher return and that’s caused by perpetual low interest rates.”

Why corporates aren’t investing

In South Africa, a lack of confidence and electricity supply constraints may be to blame for corporates sitting on the sidelines.

But the global situation is different.

Historically, corporates had to invest and take risks to expand their businesses and support share price growth, but more recently, share prices have often increased without the accompanying investment. 

Lings says in the last few years corporate share prices have performed well even in the absence of meaningful investment. Corporate executives have earned a good income, received share options that are often worth a fortune and their shareholders and executive committees have been satisfied.

“So what’s happening is the low interest rate is distorting risk taking in the world. That’s what worries Janet Yellen. So that means she will try – I stress try – and normalise rates and she needs to do it in a way that still instills confidence.”

Thus, he expects the normalisation of interest rates to happen slowly and gradually and that interest rates would remain low by historical standards.

What it means for South Africa

The South African Reserve Bank is faced with a different complexity, Lings says.

South Africa is a vulnerable emerging market with fairly substantial budget and current account deficits. The twin deficits make the country vulnerable to changes in foreign capital flows. This is also the case for emerging economies like India, Brazil, Indonesia and Turkey.

In most instances these countries have kept interest rates high relative to history to protect themselves against the vulnerability, Lings says.

In this cluster, South Africa’s interest rate feels out of line, he says.

“South Africa is vulnerable. Changes in capital flows make a difference to this country. We see it in the currency,” Lings says.

Thus the Reserve Bank is faced with a couple of issues: inflation is moving up, the country is vulnerable with low interest rates and the Fed intends to start normalising interest rates, which will naturally put pressure on other countries.

“That means the Reserve Bank feels compelled to try and move interest rates up a bit.”

But it has to be careful because moving too fast or too aggressively would undoubtedly push the economy into a recession.

“I don’t think they’ll necessarily hike again this year. The economy is weak. They do know that a lot of the selloff is global factors, but over time they’re going to have to try normalise rates,” Lings says.

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This is very odd reasoning – if companies are happy to hold onto cash at 0% interest rate would the not be even happier at 1%? Especially if they know demand will be lower as all their customers will be paying more for their debt?

The Fed has painted itself into a corner concerning interest rates due to the fact that a hike in rates will have a cascade effect in the repo markets as bond prices begin to fall as yields rise. This will cause a calamitous chain reaction, as collateral value will erode and institutions will need to provide more collateral to maintain positions. The Fed cannot raise rate and it knows it. QE till infinity.

In the days before ’08, to raise rates, the Fed would sell bills and bonds to banks, paid for from banks excess reserves, tightening available money for lending from excess reserves. This would force overnight interbank lending rates higher and that would begin effectively filtering its way through market rates. However, that was in the days when excess reserves held by banks were like $25 billion…so a little open market operation by the Fed to remove a couple billion here or there was all it took. Now, banks hold something like $2.5 trillion in excess reserves. So, for the Fed to tighten overnight rates, the Fed would need to remove something like $2+ trillion to make any impact. Not gonna happen and Fed has admitted this.

That’s why the “plan*” (* this has never been done and is totally theoretical) is to increase IOER’s (interest on the excess reserves banks hold) so banks are de-incentivized to lend as they can get higher returns parking money at the Fed?!?

All sounds pretty non-sensical until you remember the Fed works for the banks…well, then it all makes perfect sense to pay banks billions more not to lend money while simultaneously increasing interest payments for those who do take loans? There are also all kinds of concerns what happens with money market or other “non-bank” funds that aren’t eligible for IOER and what happens in times of high systemic stress.

Still, bottom line is nothing can be ruled out and the fact the Fed will continue to buy bonds while simultaneously raising rates…well, it’s just a key-stroke away from increasing it’s balance sheet and raising rates…a particularly important detail when some of the largest holders of US debt, China and Russia, are making it clear they are going to hold significantly less.

End of comments.

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