US interest rate is a trend you'll want to understand

In layman’s terms, all this means is that the US Federal Reserve wants to increase its federal funds rate, or policy interest rate. The Fed has assessed that, under appropriate economic conditions, the first increase from its current range of 0-0.25 per cent will occur this year, and it will continue to be raised over the next couple of years to its long-term target of 3.25-3.75 per cent. 

But why should Thailand, a non-US economy, care about a US rate increase? 

In theory, it will broadly affect almost all US-related interest rates, from deposits, to lending, to government bond yields, that investors all over the world hold in their portfolios. 

To me, the crucial part for Asian countries is not only the US dollar exposure but foreign-exchange risks, specifically carry risks and spot risks. 

In currencies, carry is the return one makes from holding a currency, assuming that the spot exchange rate holds constant. Popular carry strategies are typically executed by borrowing in low-yield currencies and investing in a currency with higher yield. 

For almost half a decade, the US dollar, backed by near-zero cost of funds, lured traders to borrow in dollars, paying very little interest, and use the borrowed money to invest in Asian currencies, which normally have higher interest rates, for handsome returns. 

As stated earlier, this strategy would work if and only if the exchange rate did not vary, or moved in a favourable direction. Otherwise, an unfavourable exchange-rate move could completely wipe out the profit earned from the interest-rate difference. 

In fact, a US rate increase will have two main consequences. First, the demand for dollars will increase because of higher returns. This will lead the dollar to appreciate against local currencies. 

Second, traders will unwind their positions from lower interest-rate differentials and losses from FX movement. The effect of this will lead to a sell-off of local currencies, driving down their value further. 

If the local currency depreciates by too much, it could also trigger a sell-off of other assets denominated in that currency by foreign investors who have to convert the returns back to their home currency before it is too late. 

We believe the baht is more |sensitive to the US policy rate than to those in the rest of the world, for example Japan and the euro zone. Statistically, a 25-basis-point increase in the US rate alone can lead to a depreciation of around 50 satang against dollar. 

How can we avoid this sharp swing in FX? 

Trying to maintain the interest-rate differential, by increasing the local rate, could be the easiest answer. We estimate that a 25bps increase in the Thai policy rate would make the baht appreciate against the dollar by around 30 satang.

However, we know a slower-than-expected local economy would trigger the Bank of Thailand to decrease the rate instead. This will amplify the effect of a lower interest-rate gap, which would lead to further unwinding of carry positions and selling off of the baht. 

This year is not a good one for the Thai economy. We have been facing a global economic slowdown, a prolonged drought, and low agricultural prices. Therefore, our exporters cannot expect to get full support from FX, since output may be limited and global demand may take some time to recover. 

If this US rate-increase trend continues and our economy is unable to make a comeback in time, we might run into a balance-sheet challenge as a US-dollar debtor, starting as soon as next year. Greater dollar debt and a weaker baht could push us to raise the interest rate, even though our economy may not have fully recovered yet. 

In my point of view, a US rate increase will be a key economic factor that we inevitably will face. The crucial question is: “How can we prepare our economy for this?” 

As Sun Tzu, Chinese philosopher and author of The Art of War, once said, “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

Hope for the best, but always prepare for the worst.

 

Views expressed in this article are those of the author and not necessarily of TMB Bank or its executives. Dr Jitipol Puksamatanan, capital market economist at TMB Analytics, the economic analysis unit at TMB Bank, can be reached at [email protected].