The Correlation between Fed Rate Increases and Renminbi Internationalization in 2016

Economics, Premium POM

By JC Collins

The big macroeconomic strategies which will unfold over the next 12 month period will involve the following data points:

  1. Incremental Fed Rate Increases
  2. Expanded Renminbi Internationalization
  3. Foreign Exchange Reserve Diversification, Substitution, and Reduction
  4. Beginning Phases of Sovereign Debt Restructuring
  5. Multi-Currency Baskets
  6. Regional Trading Blocs

Though all strategies are linked together, our main focus for 2016 will be on the first three, with a spattering of the last three thrown in for good measure.

With the first incremental Fed rate increase behind us, and the promise of more to come, it is worth taking a few moments to understand what the next rate increases may look like, and when they will happen.

The Fed Fund Futures determines a probability of rate increases by investors betting on what the future rates will be.  From the data we can determine that the odds of further, and larger, rate increases in 2016 are highly probable.  The following chart details these odds:

Fed Fund Futures

We can immediately notice that the odds of no further rate increases in 2016 is zero.  The odds of another increase of 25 basis points is 93% for the FOMC meeting on Jan 26, 2016.  From that date the odds of additional 25 basis point increases diminish. What we do see is that the odds of a larger increase of 50 basis points grows in probability.

The further we get into the year the further we see that the odds of even larger increases of 75 basis points grows.  This is very telling of what a broad spectrum of international investors are expecting for 2016.

The challenge for the Federal Reserve is not to increase the value of the dollar too fast and too soon. Which is something increasing interest rates would traditionally do.  Though there is a precedent which would suggest that increasing interest rates would eventually cause a depreciation of the dollar.  This is something which has been explained in a previous POM post titled Fed Rate Hike in a Changing World.

The volatility which can be expected if the Fed acts too aggressively is justified.  The initial strengthening of the USD would cause large capital outflows from the emerging markets, such as India and China.  But with the recent move by China to begin moving away from the dollar peg we can see the larger multilateral strategy begin to unfold.

In the post China Just Ended the Dollar Peg (…for the most part) we reviewed how China is moving the renminbi away from the dollar peg and towards a composite index to measure the value of the RMB.  This strategy will allow for expanded renminbi internationalization as investors feel more comfortable with the stability of the renminbi valuations.

As discussed in the post Fed Rate Hike in a Changing World, with the cost of borrowing in the US increasing, foreign investment will slow.  From the post:

“…higher interest rates will reduce the willingness to borrow and will eventually lead to a reduction in economic activity, such as mortgages, car loans, credit card use, and overall money velocity should temporarily dampen. This will cause a reduction in capital inflows.”

“After the initial response, the above factors will extrapolate the lower demand for the currency, which will cause a depreciation in exchange rate.  A depreciation which the US desperately needs to increase exports and spur domestic production to reduce the debt-to-GDP ratio before the next fiscal budget.”

We can begin to piece together the bigger macroeconomic picture.  The demand for renminbi will expand (see post Renminbi Demand is About to Explode) in correlation with a decrease in demand for dollars.  This decrease in demand will develop from both the internationalization of the renminbi, which creates an alternative to the USD denominated reserves, and the incremental rate increases by the Federal Reserve.

The depreciation of the USD which many expect to cause severe volatility will in fact lead to greater job growth and a decrease in the debt-to-GDP ratio.  There will be some volatility, such as stock market adjustments and some bond market instability, but the transition itself will unfold with the main structure of the American economy intact and growing at a brisk pace.

In order to facilitate the increase in renminbi demand and internationalization, the PBoC will incrementally widen the trading band against the USD until such a time that the valuation of the RMB against the USD is more market oriented, which will be further defined by the composite index which has just been established.

Fed rate increases, a widening of the RMB trading band, and growing demand for renminbi, will all function as tools to cause a shifting of USD liquidity into RMB liquidity.  The sloshing around will settle eventually and foreign exchange reserves will naturally become more diversified.

This strategy, as stated, allows for the dollar to depreciate without taking the whole financial world with it, like would have happened in 2008. In fact, this strategy, will see the US economy strengthen even further, which will minimize the negative effects which so many are expecting from interest rate increases.

There is much more to come in 2016.  Stay tuned.  – JC