The U.S. Federal Reserve (Fed) as expected raised the Federal Funds Target Rate by 0.25% yesterday and signaled another interest rate hike this year, a sign showing the acceleration of U.S. interest rate normalisation. What is most surprising is, the Fed for the first time outlined plans to reduce its massive balance sheet, and unveiled a roadmap of monthly reducing at maximum US$50 billion-worth treasury bonds and mortgage-backed securities, formally starting to retrieve massive liquidity injected into market during the quantitative easing (QE) monetary policy era. This means the U.S. monetary policy is tightening in all aspects. Global economy and financial markets will be subject to a new round of ups and downs.
This year the Fed has already raised interest rates three times, which indicates the U.S. enters the rate-hike cycle. With the reduction of the Fed's balance sheet taking place concurrently, the impact on the U.S. economy and even the world economy must not be underestimated. In fact, America's swift tightening of its monetary policy will not only increase the downward risk for the unstably recovering global economy, but also spark off rapid reverse of capital flow to cause turbulence in global financial markets. The bubbles of U.S. stocks and bonds may burst at any moment, which is very likely to cause another financial crisis.
Facing the dual-threat of U.S. rate hikes and the Fed reducing its balance sheet, global stock and foreign exchange markets were generally under downward pressures yesterday. Among others, Hong Kong's Hang Seng Index yesterday shed over 300 points, dropping to a three-week low. Hong Kong dollar fell below 7.78 against the greenback. The alarm is now ringing about capital flight, which becomes a potential risk for Hong Kong economy.
Norman Chan Tak-Lam, Chief Executive of Hong Kong Monetary Authority, yesterday spoke bluntly that U.S. interest rate hikes would cause more capital to flow out of Hong Kong-dollar assets, as widening U.S.-Hong Kong interest rate gap prompted more interest arbitrage activities of selling Hong Kong dollar and buying U.S. dollar. Weakening Hong Kong dollar and tightening liquidity would lead Hong Kong-dollar and mortgage interest rates to hike. Although the Monetary Authority increased the base rate by 0.25 percentage to 1.5 per cent yesterday, Hong Kong banks did not keep pace to increase their mortgage interest rates. But home buyers must not let down their guard. When Hong Kong dollar gradually approaches the weak-side Convertibility Undertaking of HK$ 7.85 to US$1.00, Hong Kong interest rates eventually will have to catch up with the U.S., which then may lead to the burst of property bubble.
The current property market is even more risky than in 1997. When the property bubble burst that year, mortgage interest rate gradually came down from 10 per cent to as low as four or three per cent. But now, mortgage interest rate is gradually picking up, so when housing prices take a downturn, the risk of mortgage loan defaults is not hard to imagine, which then will bring disaster on the real economy at any moment.
On the other hand, the impact of U.S. interest rate hikes on the Mainland's economy is temporary and limited. Even if the U.S. dollar becomes strong once again, the Mainland's economy in general maintains its stable growth and advances along the correct direction of deleveraging. In addition, the People's Bank of China (PBoC) becomes more effective than before in managing market expectations. Hence, risks of capital outflow and renminbi (RMB) devaluation are still controllable.
Nevertheless, the negative spillover effect of Fed's reduction of its balance sheet is bigger than interest rate normalisation. Its impact is not to be trifled with, and the whole world must heighten vigilance. Mainly because Fed's plan to reduce its balance sheet is unprecedented, which is seen as real tightening to retrieve liquidity injected into market during the QE era. With sharp tightening of market liquidity, multiple asset bubbles formed globally in past years will face the risk of burst one after the other. This may explain the stronger reaction in financial markets over Fed's announcement of a roadmap of reducing its balance sheet.
What is worthy of attention is, the strategy adopted by the Fed to reduce its balance sheet is more aggressive than expected. The way it pulls out of market is not limited to waiting for treasury bonds to mature but also includes selling them directly in market. The impact on financial markets is far greater than expected. 16 June 2017
