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INSIGHT: US Fed rate hike: Sell on fact

A calm market and stable US dollar mean emerging market assets look more interesting.Especially those from Indonesia.

Kahlil Rowter (The Jakarta Post)
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Mon, March 20, 2017 Published on Mar. 20, 2017 Published on 2017-03-20T08:37:53+07:00

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A calm market and stable US dollar mean emerging market assets look more interesting. A calm market and stable US dollar mean emerging market assets look more interesting. (JP/Wendra Ajistyatama)

L

ast Wednesday the US Federal Reserve raised its key policy rate by 25 basis points to a range of 0.75 percent and 1 percent. This was widely expected as Janet Yellen had given strong signals in recent weeks. Contrary to simple logic, it raised stock market indices and lowered US treasury bond yields. Also the US dollar weakened a little against emerging market currencies.

Why? And what does it portend for emerging economies like Indonesia?

We first need to understand the rationale behind the US rate hike and especially its timing. We have seen that US inflation has risen to around 2 percent and unemployment is now well below 5 percent. That means raising rates becomes necessary. And soon enough as the effect takes time to work its way through the economy, especially in the real sector.

And since the hike late last year the market has been expecting two or three more hikes in 2017. That will bring the rate to around 1.25 percent to 1.5 percent at the end of the year. Rate hikes need a calm global financial market lest they actually create more turmoil.

Yellen appears to be trying to avoid two events. First, surprises from Trump’s fiscal policy. And second, elections in Europe that have the potential to create market volatility. Hence the timing should be early enough. And in mid-March, the global financial market is calm. Commodity prices are stable and the dollar has rallied but remained stable. And the stock as well as bond markets are also calm.

If the hike was well expected by the market, why was the reaction counter-intuitive? To understand this we need to look at two things. The first is the market reaction before the policy action. The second is what the market was looking for in the announcement itself.

Before the move, the US dollar rose against major as well as emerging market currencies. And the US treasuries rose between 25 to 50 basis points. The equity market continues to rise. Hence the market is already braced for the eventual rate change.

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