Global Markets: Wrangling With a Waking Fed

A stronger dollar and higher U.S. bond yields are a double-edged sword for global markets

By Richard Barley


Chairwoman Janet Yellen’s Fed showed faith in a strong U.S. economy. All well and good, but a more active Fed may raise risks of volatility globally. Photo: Reuters


The Federal Reserve looks as if it could pull away from the global central-bank pack again. The dollar and U.S. yields are the key swing variables in what that means for the rest of the world.

Markets had pretty much universally expected the Fed to lift interest rates by 0.25 percentage point, and the Fed duly delivered. But the signal that there could be three interest-rate increases in 2017 rather than two has pushed up bond yields and the dollar sharply. The ICE dollar index has risen 1.8% in two days and reached its highest level since 2002, with the euro falling below $1.05 and the yen weakening to ¥118; the 10-year Treasury yield rose above 2.6% Thursday.

For developed markets such as Europe, the Fed’s faith in a U.S. expansion is probably good news. The European Central Bank, despite market nerves over its decision to extend its bond purchases at a reduced pace, isn’t going anywhere on rates—much like other central banks.

Monetary-policy divergence is arriving, and clearly visible in the gap between two-year German and U.S. yields, which has vaulted to over 2 percentage points, having spent months fluctuating around 1.3 points. A weaker euro should help the eurozone and a moderately steeper yield curve is already buoying European bank share prices, which is a positive development.

For emerging markets, the picture is more mixed. Currencies from the Mexican peso to the South African rand fell against the dollar. That could complicate life for borrowers with U.S. dollar-denominated debt. Some countries are clearly facing tests, like Turkey, where the lira has declined by 17.5% this year against the dollar, prompting the central bank to raise rates even as the economy slows. But emerging countries already saw big outflows after the so-called taper tantrum of 2013. That makes them potentially less vulnerable. The recovery in commodities prices also should help exporters.

Still, the world is faced with an odd mix of forces. Markets have bought into reflation in the U.S., spurred by Donald Trump’s election victory, and the Fed appears to have bought that story, too. A stronger U.S. economy should be good news for global growth, which already was showing signs of gaining momentum in the second half of 2016. But at the same time, a more active Fed raises risks in a world where ultra-generous monetary policy has been the buffer against volatility.

Much will depend on the speed of gains in the dollar and yields. Too rapid a surge in either would likely upset global markets.

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