Federal Reserve Chairman Jerome Powell made it clear that his strategy on interest rate hikes will be guided by the real time performance of the US economy, not the estoric econometric models of the central bank’s staff monetary economists. Unlike Ben Bernanke, Alan Greenspan and Janet Yellen, Powell is not an economist but a former Wall Street lawyer and private equity executive. This is the reason he signaled that he will not try to short circuit the strength in the labour market or the impact of the Trump tax cut on economic growth.
As expected, the Powell Fed raised the overnight borrowing rate by 25 basis points at the March FOMC and will raise interest rates twice more in 2018. A third rate hike is possible if payroll growth accelerates or wage inflation spikes above 3%. However, Powell downplayed the risk of an acceleration in inflation, the reason the US Dollar Index fell to 89.60 after the FOMC announcement. Jay Powell believes that the Philips Curve, while it exists, has been relatively flat since the 2008 global crisis.
After six Fed rate hikes since December 2015, the Fed Funds rate is 1.50% or the highest since Lehman’s failure. However, it is undeniable that Powell’s first FOMC enclave envisions a faster pace of Fed monetary tightening in 2018 and 2019.
As I write, three month LIBOR is fixed at a 2.286%. This bellwether interest rate for global bank loans, home mortgages and financial derivatives has now risen for 32 consecutive days. The consistent widening of the LIBOR – overnight index swap spread all suggests that liquidity is declining in global financial markets even as systemic credit risk rises. LIBOR is also rising because US Treasury bill issuance has increased, with an upward pressure on money market yields. Since the current Fed dotplot projects at least six more rate hikes in 2018 and 2019, I would not be surprised to see three month LIBOR rise to at least 3.50% in the next twelve months and for many non-US borrowers and banks to face dollar funding pressures. While systemic risk is nowhere near the levels of 2008 (Lehman, GFC) or 2010-11 (Club Med debt), I believe a bloodbath in the illiquid, leveraged segments of the corporate/high yield bond market will only worsen, particularly for highly indebted unrated corporate/sovereign borrowers. It is time to track banking and sovereign stress real time in the credit default swap market. After all, the LIBOR – overnight index swap (OIS), a metric of bank credit risk, was last 56 basis points in 2009. This crucial risk spread has doubled since early 2018.
Since the UAE dirham is pegged to the US dollar, any increase in US Treasury bill issuance since Congress raised the debt ceiling means higher LIBOR and thus higher UAE dirham bank funding rates (EIBOR). These funding costs will only increase as the US tax cut leads to a spike in the US budget deficit and the Federal Reserve continues its monetary tightening program.
The rise in LIBOR will also have a tangible impact on Saudi Arabian monetary policy and financial markets. Saudi central bank SAMA raises its repo rate for the first time in almost a decade ahead of the Fed rate hike. Saudi Arabia’s SAIBOR and UAE’s EIBOR actually trades below LIBOR as I write. This means bank funding costs and loan pricing will tighten in the GCC, not exactly a positive omen for highly leveraged property developers and corporate borrowers. The Hong Kong dollar has also depreciated to 7.85, the lower end of its trading range. This means the Hong Kong Monetary Authority (HKMA) will be forced to withdraw liquidity from the ex-Crown Colony’s money market, a move that could well deflate Asia’s biggest property bubble. As US tax reform gains momentum, I expect LIBOR to trade well above its similar maturity risk free rate because funding markets outside the US will tighten. The rise in LIBOR was a contributory factor in the global banking stock carnage last week. Note that Citigroup shares now trade well below their book value of $71 a share.
The upside breakout in sterling I expected last week has now happened. The 7 – 2 vote in the Bank of England’s MPC is sterling positive, as is February retail sales data. Now that the Old Lady of Threadneedle Street has said “ongoing tightening is necessary to hit its inflation targets, expect two BOE rate hikes in 2018. This means sterling rises to 1.46.
Currencies – The Pakistan rupee can depreciate to 120 by end 2018
A depreciation of the Pakistani rupee is now a high probability event. With external debt at $93 billion or 29% of the national GDP, I am alarmed by the significant deterioration in the State Bank of Pakistan’s hard currency reserves from $16 billion to a mere $12 billion in the past year. There is no time for Pakistan to issue another sovereign Eurobond as the PML – Nawaz government’s term ends in May, with Finance Minister Ishaq Dar facing an arrest warrant on his return from London for medical treatment and Prime Minister Nawaz Sherif disqualified by the Supreme Court. As if political risk was not bad enough, Pakistan faces a higher current account deficit due to CPEC related outflows and the rise in Brent crude prices. A Lula win in Brazil or a López Obrador win in Mexico could easily trigger emerging markets contagion at a time of rising Federal Reserve monetary tightening. Trump’s tariffs against China could not have come at a worst time for Pakistan.
The IMF projects Pakistan’s current account deficit will rise to $15.7 billion or 4.8% of GDP. Pakistan also faces an external financing need of $24 billion and a debt service cost $6.3 billion or 26% of exports. It is alarming that the State Bank of Pakistan’s hard currency reserve have fallen so significantly even though Islamabad has borrowed in the Euro bond market only four months ago and has access to international commercial banking lines.
The Achilles heel of Pakistan, as ever, is the luxury import appetite of its elite (no shortage of Beamers and Benzis in Clifton/Defence!), its 90-billion-rupee circular debt, its pathetic tax collection/GDP ratio, its inability to accelerate export growth, its disproportionate, Prussian scale, military budget and the weakness (both real and induced by the deep state) of its democratic institutions.
The prospect of Imran Khan’s PTI in coalition with Asif Zardari’s PPP and smaller religious parties, as happened in the Senate, winning the July 2018 general election is a nightmare for any international investor, the reason offshore money has been selling Pakistani equities. I was stunned to see the turnover on the Karachi stock exchange on a day I was in town last week was a mere $27 million, less than the notional size of an average day on my trading desk!
Pakistan is thus very vulnerable to both domestic and external financial shock in the summer and autumn of 2018. I do not remotely expect a sovereign debt crisis. The IMF’s implied risk neutral sovereign probability of default is a mere 6.5% and the credit default spread is high (but not draconian) at 342 basis points. Yet I cannot see how Pakistan can escape a depreciation of the rupee under its central bank’s managed exchange rate regime and would not be surprised to see the Pakistani rupee fall to 120 against the US dollar by year end 2018.
This conviction has profound implications for any strategic view on Pakistani equities. The Karachi index trades at 9.4 times earnings, far below the MSCI Asia ex Japan valuation multiple of 13.6 times earnings. Pakistani equities also offer a dividend yield of 5.3 and 3-year rupee bonds auctioned by the central bank yield 6.8%. Yet my rupee view wants me to position money into OGDC and Pakistan Petroleum Ltd., who benefit from a rise in US dollar revenues if the rupee tanks while local operating cost decline.
Fears of a rise in the debt receivables could pressure Hub Power Co. down to its 52-week low at 89, where I find it irresistible. Lucky Cement and United Bank Ltd. are my other favourite blue chips, though not at current prices.