Federal Reserve (Fed) Board Chair Janet L. Yellen earlier made hawkish remarks, stressing that it was appropriate for the Federal Open Market Committee (FOMC) to hike interest rates in upcoming meetings, as long as the performance of the labour market and inflation met expectations. Markets have reacted positively, seeing it a sign showing "solid growth" of the US economy. US shares hit a new record high, leading global stock markets to rise to near their historical highs. Among them, Hong Kong shares yesterday soared nearly 300 points once rising above the 24,000 mark, and single-day trading sharply jumped to over $110 billion.
Details and effectiveness of US President Donald Trump's tax reduction still remain unknown, but the US and global stock markets already tend to grow exuberantly. Investors must be extremely cautious about potential market risks. At present, the US economy is seemingly good yet also worrisome. In particular, the Fed intends to speed up rate normalisation, which inevitably will increase uncertainty and risk in the world economy and finance. In addition the Fed plans to reduce the size of its balance sheet, which means it will gradually retrieve excessive capital from market. Stock, foreign exchange and bond markets will face a real test.
As a matter of fact, Yellen's remarks at a hearing of the Senate's Committee On Banking give the impression that the Fed is more optimistic with the US economic outlook and it would not wait to hike interest rates until the Trump administration unveils its fiscal policy. Therefore, the pace of US interest rate hikes could be quicker than market expectation. It is worrisome that the global financial market is not prepared for this, hence investors should not underestimate the risk of US interest rate hikes, which will continue to be a source for turbulences in global stock, foreign exchange and bond markets.
What is worthy of attention is that since the start of the 2008 financial crisis, the Fed has launched several rounds of quantitative easing (QE) monetary measures, injecting a large amount of money i.e. liquidity into market. As a result, the size of the Fed's balance sheet has sharply expanded by multifold, from less than US$1 trillion before the crisis to the current US$4.5 trillion. Yellen earlier revealed, for the first time, that the Fed would discuss the issue of reducing the size of its balance sheet in next months with an aim to trim it down to far below the current level. This implies the inevitability of the Fed reducing the size of its balance sheet, which means it won't re-inject the cash it retrieves, when treasure bonds it now holds mature, into market to buy in bonds. This will produce the effect of tightening money supply. So the current phenomenon of liquidity excessiveness is bound to reverse to exert certain pressure on prices of assets such as shares, foreign currencies and bonds.
The US has raised interest rates twice in past more than one year, which also has a tightening effect. However, the pace of rate hikes is very slow and financing costs just increase slightly, so the negative impact on financial market is not so big. However, the Fed's move to reduce the size of its balance sheet is no trivial matter, which definitely will have a greater impact on markets. Once the size reduction is in terms of a couple of trillions of US dollars, market liquidity will be remarkably tightened, making US bonds and shares to suffer.
Apart from the trend in interest rate, uncertain factors in US policies will also continue to disturb global economic and financial markets. In fact, following Yellen's hawkish remarks, the US Dollar Index (USDX) immediately jumped to three-week high. All this goes against Trump's advocate for adopting a weak-dollar policy to stimulate the economy.
More importantly, at the Senate hearing Yellen criticised Trump's move to ease financial supervision, stressing that the Dodd-Frank Wall Street Reform and Consumer Protection Act restricting banks to engage in high-risk deals was very important. Thus she explicitly challenges Trump. This prompts concerns whether Trump would move to punish the Fed, even firing Yellen. This would further increase turbulence in global financial market.
Thanks to capital coming down from the north, Hong Kong stock market has led the global market to rally since beginning of this year. However, attention must be paid to it that a strengthening US dollar is likely to cause capital outflow. Hong Kong dollar's exchange rate against the greenback dropped to a two-month low last night, which could be seen as ringing an alarm.
16 February 2017
