How a Fed Rate Hike Could Impact Global Markets

Rising Interest Rates & the Impact on International Markets

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The U.S. Federal Reserve made it clear that it would raise interest rates in 2015, as long as the economy continues to improve. In anticipation of rising interest rates, the U.S. dollar has appreciated in value and put pressure on the balance sheets of banks, firms, and households that borrow in dollars and spend in other currencies, while also putting pressure on exchange rate regimes linked to the dollar that do business in other currencies.

Emerging Market Spillover

Emerging markets received about $4.5 trillion of gross capital inflows between 2009 and 2012 – representing about half of global capital flows – thanks to the low interest rate environment across developed countries following the 2008 global economic crisis. Alongside the capital influx, equity and bond prices rose higher while currencies appreciated in value, as it became cheaper to borrow and investors sought yield outside of developed country borders.

As the U.S. normalizes interest rates, emerging market economies have begun to experience capital outflows. Investors received a taste of these outflows in May and June of 2013 with the so-called “taper tantrum” episode, where emerging markets suffered from indiscriminate capital outflows that dampened their economy. The bad news is that the timing and pace of these interest rate hikes could catch the market by surprise.

The chart below illustrates the change in the Fed funds rate from 2000 through today.

After the Federal Reserve increased its rhetoric, during the first half of 2015, emerging market equities, bonds, and currencies began falling in value once more. Some experts are worried that the central bank’s tightening could precipitate a financial crisis in emerging markets, much like those that happened in 1982 and 1994. Countries like Fragile Five may be especially susceptible to these types of crises since they failed to strengthen their domestic budgets.

Divergent Developed Markets

Emerging markets aren’t the only countries affected by the Federal Reserve’s rising interest rates. European and Japanese economies will benefit from the depreciation in the euro and yen, but portfolio rebalancing could take away some of those benefits.

With capital moving back to the U.S. following a potential rate hike, Eurozone countries could experience higher borrowing costs that could impact economic growth rates.

That said, loose monetary policy by the Bank of Japan and European Central Bank could help offset the impact of Federal Reserve tightening on emerging market inflows. These offsets aren’t as effective as low interest rates in the U.S., however, given that many emerging markets have dollar debt instead of euro debt, which makes them far more susceptible to movements in the U.S. dollar than that of the euro or other European currencies.

It’s also worth noting that the Bank of England has indicated that it would put an end to its quantitative easing program and hike interest rates in May of 2016. While the move isn’t as significant as U.S. or E.U. decisions, it could still influence the region by sucking up international capital flows.

Key Takeaways

  • The Federal Reserve anticipates a rate hike in 2015, which has been a big cause of concern both domestically and internationally.
  • Some experts are concerned that emerging markets could suffer the most from a rate hike since it would draw capital away from their economies – an effect known as the “taper tantrum” that has already been observed back in 2013.
  • Developed markets could experience lesser demand for their sovereign debt, which could result in more expensive financing for quantitative easing and other stimulus programs.