Dovish central banks are in favour of low interest rates, while a hawkish one pursues rate hikes to slow growth and tame inflation. Dovishness is generally supportive of risky investments like equities, as individuals and corporates have fewer incentives to save and it is cheaper to borrow money to consume and invest. Hawkish behaviour can have the opposite effect.
In December, the US Federal Reserve raised interest rates for the first time in almost a decade. Since then, markets have been closely watching their statements to try to predict the timing and pace of future interest rate hikes. Equity markets fell sharply in January and February as Chinese economic growth concerns resurfaced. Expectations for a rate hike fell alongside markets, as the Fed acknowledged the impact that increased market volatility could have on the US economy.
Come May, however, the tack has changed a little following further market calm. Recent statements from the Fed are sounding more hawkish, indicating increased confidence in the economic outlook. This has since been supported by stronger economic data and company earnings reports. All of a sudden, investors are now pricing in a higher chance of a rate hike in June or July.
An emerging emergency?
Markets are now showing signs that they feel a little bit uneasy about a rate hike. If US interest rates rise, investors could move more money into US dollars, pushing up the currency’s value. This means money flows out of emerging economies and back to the US, which in turn lowers the value of emerging market currencies, making it harder for them to repay US dollar debts. The pace of rate hikes is still forecast to be relatively slow, so this is no emergency yet for emerging markets, but it could end that way if the Federal Reserve becomes increasingly hawkish.
What does all this mean?
The combination of the threat of of higher US rates and further Chinese economic slowdown means we remain cautious on emerging market investments. US dollar and US government bond exposure should be carefully monitored, although the effects of recent hawkish statements have been limited so far in these asset classes.
Our economists see a July hike as increasingly possible, but if financial markets remain relatively calm and US data continue to improve, a June move is not off the table. Let us hope that central bank activities do not become as menacing and unpredictable as Hitchcock’s birds, or else the horror movie may become a reality. And this time it will be financial markets that are ducking for cover.