Financial markets have dramatically revised their expectations of Fed policy conduct in 2024. After the global financial crisis (GFC), bond investors embraced a secular stagnation thesis for the US economic outlook, requiring permanently easy monetary policy. Consequently, they played an almighty game of chicken to force the Fed to accept their dovish policy prescription.
The secular stagnation thesis still prevailed during the period of rising inflation after the pandemic. Once the Federal Open Market Committee (FOMC) changed their policy rate outlook in December to three reductions in 2024, the game of chicken quickly returned in January. Investors discounted seven rate cuts. Courtesy of strong economic data, however, their assessment fell from seven to its current two (due in September and December).
Hence, bond investors have become more hawkish than the FOMC for the first time since the infamous taper tantrum in 2013. Consequently, this could herald a new era of more realistic Fed policy expectations being formulated after years of dovishness.
June’s FOMC Meeting: Critical for Policy Expectations
Adjustments to the FOMC’s forward guidance are conveyed in their Summary of Economic Projections, the next due after June’s policy meeting. Fed policy conduct remains firmly data dependent. Incoming information before the next FOMC meeting will, therefore, shape potential forward guidance changes for 2024 H2 and 2025 H1. Investors could easily change their expectations in either direction, depending on incoming data. Meanwhile, the Fed’s preferred inflation gauge, the personal consumption expenditure (PCE) deflator, is still displaying a disinflationary trend, unlike the consumer price index.
Crucially, the continuation of disinflationary PCE trends creates leeway for the FOMC to enact their current forward guidance in H2. Meanwhile, the FOMC has reverted to an asymmetric approach to strong employment gains, relying on immigration to quell wage inflation pressures, as opposed to higher unemployment. Hence, policy rate reductions and strong job growth are currently viewed as being completely compatible.
The Looming End of Quantitative Tightening: Benefits for ASEAN Borrowers?
Interest rate reductions form one pillar of Fed policy easing: the other is reduced quantitative tightening (QT). Slowing the shrinkage of the Fed’s balance sheet via tapering should help reduce pressure on US long-term interest rates. The timing of the start of tapering remains, however, somewhat uncertain, but it should start the eventual closure of QT. Ending QT should impart benefits to ASEAN credit markets, particularly those where there are significant numbers of corporations borrowing in US dollars.
Meanwhile, the overall impact of QT tapering could depend heavily on the reaction of the term premium embedded in long-term interest rates to future Fed policy rate cuts. If bond investors’ view Fed rate cuts as being risky, then long-term interest rates could rise due to term premium pressures, which would ironically tighten financial conditions. This outcome would, therefore, be perverse for US dollar borrowers in the ASEAN region who seek to refinance debt in 2024 and 2025. Meanwhile, ASEAN central banks are unlikely to be slaves to the Fed’s conduct due to past policy measures, as well as ongoing currency weakness.
ASEAN Central Banks Face Different Challenges
The Fed led the charge towards higher policy rates in early-2022. ASEAN central banks duly followed, but only Vietnam, Indonesia, and the Philippines exceeded the Fed’s peak level. Meanwhile, more hawkish expectations about the path of Fed policy have significantly complicated the ASEAN monetary policy outlook due to downward pressure on local currencies. Varying domestic economic conditions and currency pressures imply that a “one size fits all” regional monetary response is impossible.
The scope for monetary easing when the Fed eventually cuts its policy rate is more restricted in Indonesia and the Philippines due to higher inflation and currency weakness. Meanwhile, Malaysia and Thailand have their respective central bank policy rates below the Fed’s current level. Both countries are experiencing weak external demand and soft currencies. Given that ASEAN central banks face limited scope to ease policy rates, local currency bonds and equities face stiffer headwinds than envisaged at the start of the year. Ultimately, local currency bonds and equities will benefit once central banks begin reducing their policy rates.
Arguably, currency depreciations have already effectively eased local financial conditions ahead of ASEAN central bank actions. Countries with weakening currencies will import both growth and inflation. Thailand and Malaysia should have less concern about currency weakness compared to Indonesia and the Philippines due to their lower inflation rates.
Better Economic Backdrop for ASEAN Risky Assets in 2024
Unfolding events in China and the US will have strong influences on the economic outcomes of ASEAN countries reliant on external demand. China and the US remain the main drivers of global growth. Meanwhile, the economic outlook for the ASEAN region has been revised upward since the start of the year due to resilient domestic demand and modest improvements in net exports, thereby providing a better backdrop for risky assets. Crucially, ASEAN capital markets have become less hostage to foreign capital flow disruptions since the Asian Financial Crisis. Except for Indonesia, duration equivalent sovereign bond yields in the ASEAN region are below the 10-year US Treasury note without any semblance of local market disruptions.
ASEAN equity valuation risks seem more limited compared to the US, particularly in Indonesia, Philippines, and Singapore. These markets trade on a P/E multiple of 11-12. Relative to history, current valuations are cheap. Malaysia, Vietnam, and Thailand are trading on higher P/E multiples, ranging from 15 to 17, and, consequently, appear more fairly valued to historic norms.
The importance of overseas portfolio inflows is often over-hyped in terms of gauging economic optimism for a region. Foreign direct investment (FDI) flows are far more important in terms of magnitude. The outlook for FDI into the ASEAN region is bullish, underpinned by favourable demographics and the diversification of supply chains by multinationals. Crucially, rising FDI is beneficial for boosting productivity and reducing inflation in host countries. Hence, higher secular regional equity valuations are both potentially achievable and sustainable, even without major help from the Fed and regional central banks.
Author: Said Desaque | Said is a professional economist with over 35 years of experience covering the global economy, with significant expertise in the US, China, Japan and emerging markets. He has worked with US investment banks for over 25 years covering institutional investors in Europe, Middle East, Far East and Australia.
