Big green light

Fedphoria: With growing clouds on the economic horizon and a growing disconnect between the effective Fed funds rate and market expectations, the Fed’s dovish shift has prompted still more rate cut bets .

While the updated Fed dots still show no change for the rest of 2019, the median interest rate forecast of Fed officials now suggests a quarter basis point reduction in policy rates next year (reversing course from previous forecasts of a 2020 rate hike).

Future markets have priced in 2 rate cuts (and the possibility of a third) by the end of the year, with odds of about 70% for a July cut. While the Fed’s latest shift doesn’t change the remarkable disconnect between the Fed dots and market rate expectations, the focus has shifted to the implications of a potential global synchronized easing.

Indeed, as trade tensions wear on, slumping business confidence has already provoked many central banks to turn more dovish this year. The ECB opened the door to renewed asset purchases and further rate cuts earlier this week, with money markets currently pricing in an 85% chance of a 10bp cut in the deposit rate by December.

Australia, Canada, New Zealand, Mexico and Japan too are expected to follow suit on rate cuts. And after dovish statements from the Fed and ECB, many EM Asian central banks may turn to easier monetary policy to cushion threats to export markets.

Futures Markets and Rates

As dovish central banks fuel risk assets, weaker USD has provided EM currencies with some breathing space, U.S. stocks have reached new record highs and bond yields have dropped across the globe, bringing the value of negative yielding bonds to a new record high of over $12.5 trillion.

Looking forward, another “big bazooka” from key central banks should boost sentiment and lift global economic activity. However, it also raises concerns about the distributional and financial stability implications of yet another prolonged period of low interest rates.

In an environment of a synchronized easing, exchange rate movements will be at the centre stage of the policy debates.

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Although loose monetary policy, by and large, tends to be associated with weaker currencies, the ultimate impact will of course depend on the relative pace of easing compared to other countries.

Indeed, available CFTC data reveal that investors are still largely long USD against major mature market currencies, suggesting that market participants believe that Fed stimulus in the pipeline might not end up being enough to weaken the USD.  

USD vs. EM currencies

Against this backdrop, a strong U.S. dollar would mean higher funding pressures for borrowers outside the USD, particularly for those with high levels of USD-denominated debt. Refinancing pressures could be even more challenging for non-financial corporates in mature markets (ex-U.S.) that have seen a sharp accumulation in USD-denominated debt since the 2008 financial crisis.

For this group, USD-denominated debt has risen from 15% of GDP in 2008 to over 25% at present. Of note, emerging markets ex-China have not seen such a big build up in USD debt—it has risen by only about 5 percentage points to 15% of GDP.

Dollarization since 1998

Global corporate debt pileup set to accelerate:  While lower global rates (in a scenario of synchronized easing) should reduce the cost of capital—in turn helping to support business sentiment and capital spending— they will also widen the gap between cost of equity and cost of debt.

This gap, which is already substantial, will encourage corporates to turn even more to debt financing rather than equity financing, particularly in countries with low stock market valuations. This could well trigger a further acceleration in corporate debt accumulation.

The rise could be particularly pronounced in emerging markets such as China, where the gap between cost of equity and cost of debt is persistently high, and relatively low stock valuations limit corporates’ appetite for equity financing.     

Build-up in corporate debt

Surge in Panda bond issuance: While still at an early stage of development, onshore CNY bond issuance by foreigners has been on an upward trend since early 2018.

With total issuance exceeding $6 billion over the past 12 months, so-called Panda bonds are expected to gradually replace dim sum bonds (offshore RMB bonds) as they offer lower borrowing costs than offshore RMB bonds.   

Growth in Panda bond issuance

While a significant portion of Panda bonds is issued by corporates in Hong Kong, the rise in the share of European issuers, mainly in Germany and France, has been notable in recent years, reflecting increased interconnectedness between China and Europe.

China’s massive Belt and Road (B&R) initiative has been another important factor supporting neighbouring foreign governments (Pakistan, Philippines) appetite for Panda bonds—in part reflecting their efforts to finance B&R-related infrastructure projects.   

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