News analysis

How the reversal in ultra-loose policy affects investments

With economic activity percolating worldwide, the argument for maintaining ultra-loose policy is fast losing credibility among developed market central banks.

The Federal Reserve, the world's beacon for monetary policy direction, looks set to hike interest rates later this year, the fifth time since the global financial crisis (GFC), and to start reducing the size of its balance sheet.

Nonetheless, inflation worldwide has been lower than anticipated. The withdrawal of liquidity globally will therefore be gradual and unlikely to alarm bond markets. We expect the US 10-year Treasury yield to rise moderately to 2.5 per cent over the next six to 12 months, while ageing demographics and the global savings glut should keep the 10-year benchmark yield firmly capped at 3 per cent until 2019.

Still, as one central bank after the next take steps to move away from the post-GFC era of super-easy policy, the implications for regional and worldwide assets could be profound.

Borrowing costs rising in Hong Kong and Singapore One consequence will be higher borrowing costs in Hong Kong and Singapore. The monetary regimes of the two city-states are strongly influenced by the Fed's. So when United States interest rates rise, theirs typically do too. With another Fed hike on the horizon, higher three-month interbank offered rates in Hong Kong (HIBOR) and Singapore (SIBOR) are likely over the coming quarters.

But they will not follow in lockstep with the Fed: At present, both the HIBOR and the SIBOR are trading at a discount to the US dollar London interbank offered rate (LIBOR). The HIBOR discount is currently around 50 basis points. This large gulf is due to the ample liquidity conditions in Hong Kong, as money supply growth has accelerated to 15.9 per cent year on year - the fastest pace since December 2007. Such flush liquidity conditions are a result of mainland Chinese investors channelling their money into the city as a way to protect their investments from a weakening domestic currency, as well as foreign investors placing funds in the city as a conduit for investment in China.

A weaker US dollar and the Fed's slow hiking path should preserve the HIBOR's discount to the LIBOR. In Singapore's case, the three-month SIBOR should rise to 1.5 per cent in six months and to 1.8 per cent in 12 months. The divergence versus the US dollar LIBOR should be relatively limited as the demand for SGD is dampened by the Monetary Authority of Singapore's (MAS') non-appreciation exchange rate policy, which should hinder potential gains for the currency.

MAS has indicated that it will maintain this policy for an extended period. We see the SGD trading at around 1.38 against the US dollar for the next 12 months, making it a relative underperformer versus other currencies in the region.

For SGD-based investors, its low carrying cost makes it an ideal funding currency for a long position in the Indonesian rupiah, which has an attractive yield of around 4.5 per cent per annum. Given Indonesia's improved current account dynamics and its significant build-up of forex reserves over the past few years, the rupiah appears well placed to withstand a gradual rise in US interest rates.

Don't bet on further strength in Asia-Pacific currencies The US dollar's sell-off has brought Asia-Pacific currencies close to the threshold levels of many central banks. The Reserve Bank of Australia responded swiftly to quell markets' perception of imminent rate hikes, after the latest central bank minutes sparked a currency rally by referring to a "neutral nominal rate" of 3.5 per cent, which is much higher than the current policy rate of 1.5 per cent. The Thai central bank said that the baht has strengthened "too fast recently", pointing to the currency's 2.3 per cent rally in the past month. The SGD nominal effective exchange rate, meanwhile, has risen close to the upper bound of MAS' policy band, and a further move to that level could warrant forex intervention by the central bank.

Moreover, several market indicators signal that Asia-Pacific currency strength against the US dollar could start to consolidate. Speculative net short US dollar positioning is now at around US$9.7 billion (S$13 billion), levels not seen since February 2013. Also, interest rate markets are now pricing in less than a 10 per cent chance of a Fed rate hike next month and a 40 per cent chance of a Fed hike by December. Given such bearish sentiment on the US dollar, the risk appears skewed towards a US dollar recovery versus Asia-Pacific currencies should US economic data surprise positively.

Euro strength exceeds expectations The euro's appreciation against the US dollar last month exceeded expectations, rising from 1.13 to 1.18. As the US dollar weakened across the board, the euro soared on solid euro zone economic prints and expectations of European Central Bank (ECB) tapering. The bloc's economy has expanded for 17 straight quarters, and unemployment hit an eight-year low of 9.1 per cent in June. Attention has now turned to the ECB's meeting next month, where an announcement about the tapering of its asset purchase programme is expected.

We expect the euro to gain even more ground against the US dollar and reach 1.2 over the next 12 months. While the euro's swift gains in recent weeks have begun to hurt euro zone equities, the relative underperformance of euro zone stocks looks overdone. As a relatively open economy - with 50 per cent of revenues generated outside the region - the euro zone is benefiting from a synchronised upswing in global demand.

Gold - a viable insurance asset Although we remain overweight on global equities and do not expect a major increase in market volatility in the near term, gold's asymmetric return payoff makes the yellow metal an interesting insurance asset.

The opportunity costs of holding gold are low as US real interest rates should continue to stay negative. Also, the absence of catalysts for US dollar strength as well as rising demand among wealthy Asian buyers should keep gold prices from falling below US$1,200 an ounce.

So, if benign macro conditions persist, gold could trade at US$1,250 an ounce, incurring minimal costs for investors in a pro-risk market.

For investors in Asia, where shifts in the local equity markets are highly correlated with shifts in the underlying currencies, gold's insurance qualities may be even more valuable.

•The writer is the Asia-Pacific regional head at the chief investment office of UBS Wealth Management.

A version of this article appeared in the print edition of The Straits Times on August 07, 2017, with the headline 'How the reversal in ultra-loose policy affects investments'. Print Edition | Subscribe