The following posts cover the period:
up to the first rate hike: Fed Rate Liftoff, KOSPI Range-Bound Volatility, and the Year-End Resolution of Rate-Hike Uncertainty (2015.12.18.)
up to the second rate hike: Fed Post-Liftoff Dossier: Employment Distortions, Oil Deflation, and the Macro Path of the KOSPI (2016.12.15.)
Since August, I have consistently maintained that a September rate hike by the Federal Reserve was improbable, and even if executed, its marginal scale would serve as a catalyst rather than a deterrent for the South Korean equity market. I previously articulated this conviction in a post approximately two weeks ago.
While many investors stayed awake until 3:00 AM (KST) to check the FOMC announcement, I opted for a sound sleep.
[Fed Holds Rates Steady] Brokerages Put Greater Weight on a December U.S. Rate Hike (2015.09.18.)
Although this decision may provide short-term liquidity relief, the long-term outlook remains clouded. As the saying goes, it is better to get the pain out of the way early, but instead the market was rattled for weeks only to end up back where it started; in any case, this is something that had to be dealt with sooner or later. Significant monetary tightening is unlikely until the Chinese economy stabilizes further and U.S. labor indicators show meaningful―rather than merely statistical―improvement.
While many pointed to improving employment data as one factor raising the odds of a September rate hike, I’ve been arguing since June that these numbers are little more than a statistical mirage on paper. Nevertheless, as the underlying trend suggests gradual recovery, so I expect gradual rate hikes to begin before next March.
From a technical analysis perspective, I expect the KOSPI to recover to the 2,050 level before year-end. Regarding Bank of Korea Governor Lee Ju-yeol’s recent hints at a possible October hike, I view such statements as a kind of reputational insurance—a common tactic employed by high-ranking officials to preemptively hedge against potential errors. Unencumbered by the weight of such professional reputation―because I have no such reputation to protect―I maintain my stance that no U.S. rate hike will materialize until next year.
Foreign buying started to return yesterday (2015.09.17.), the day before the announcement, and domestic institutions have been net buying for about a week. If I had had more cash, I would have been buying aggressively as well last week; since I was short on capital, I was limited to stable blue chips and could only watch the volatile stocks hitting limit-up from the sidelines. Even so, by making small adjustments every day, I ended up with more positions up over +5% than positions I cut at around -2%. The sums are so small that the gains are basically just lunch money, haha, but still.
Several readers asked why I think an immediate Fed rate hike is unlikely, so I’m explaining my rationale below. I’m leaving out the detailed data for the sake of brevity and instead focusing only on the basic theoretical outline.
Federal government debt, which stood at approximately $9 trillion at the end of 2007, has now exceeded $19 trillion, meaning that more than $10 trillion in debt has been added over the past eight years. At this scale, even a Treasury yield of just 2% generates $380 billion in annual interest payments. Meanwhile, the Federal Reserve printed more than $2 trillion and used it to buy Treasuries in the market at elevated prices. The purpose was to support Treasury prices while the United States continued to carry a heavy debt burden and chronic fiscal deficits.
Many people describe this by saying “helicopter money was sprayed into the market." But the dollars printed by the Fed were simply exchanged for Treasuries and ended up on the Fed’s books; it was not as if the Fed had taken money out of its own coffers and scattered it into the market. What was injected into the market was liquidity. In other words, the Fed did not exchange capital for debt; it exchanged one form of capital for another. (Alchemy?) One might wonder how this is any different from debased coinage, but it is a cheat code available only to the issuer of the global reserve currency. Whether this alchemy can be used forever is another question.
⑴ As noted above, “the money printed by the Fed has merely been exchanged for bonds and sits in the Fed’s vault." That is, the Fed is, in effect, holding bonds on the asset side of its balance sheet against the dollars it created. If the value of the bonds held by the Fed rises, some of the pressure on its balance sheet can be eased.
⑵ The only way to melt away, on a large scale, the real value of nominal debt that has already been created through funding secured at low fixed rates is inflation. In other words, real interest rates must remain low while waiting for inflation in the real economy to rise. Only then will the decline in the dollar’s value ease the real debt burden associated with the massive stock of fixed-rate Treasuries already outstanding. At the same time, nominal tax revenues boosted by inflation in the real economy will make it easier to retire outstanding fixed-rate nominal debt. Taken together, these effects will generate a kind of multiplier effect, thereby dramatically improving fiscal soundness.
⑶ But what happens if the Fed raises the policy rate now? Inflationary pressure in the market will be suppressed, making it difficult for nominal tax revenues to increase significantly; the market value of the bonds held by the Fed will fall as market rates rise; the federal government’s debt-servicing burden will continue to grow as nominal interest costs increase; and, as the dollar appreciates, the real burden of those enlarged nominal interest costs will become even heavier. In other words, a Fed rate hike―if it happens now―would amount to a fourfold burden.
For these three reasons, it is difficult for the Fed to move immediately from tapering to a policy-rate hike. Over the next several years, inflation will inevitably emerge as a result of the liquidity created through large-scale nominal money issuance over a prolonged period of ultra-low interest rates―in Europe and Japan, real interest rates were negative―as policymakers dealt with the aftermath of the 2008 financial crisis.