Despite the huge surge in market volatility the past three days and the tumultuous drop in US equities, these moves tell us nothing about the state of the US real economy. China is having its problems, largely the result of its own policies and imbalances that it has created in a non-market economy. Those problems have been exported to commodity countries and those with close ties to China but are – as we have recently written – largely irrelevant for the US, except with regard to the following observations.
First, China’s problems and inept policies should quell talk for the foreseeable future about the role of the yuan as a reserve currency. These developments mean that the US is the safest place to be: the flight to quality means a flight both to the dollar and to US Treasuries.
Second, the flight to quality will continue to put upward pressure on the value of the dollar and downward pressure on Treasury yields. These pressures will further reduce the cost of US imports to the benefit of consumers and intermediate goods users. US exports will become a bit more expensive but will be largely influenced by developments in our major trading partners – namely Mexico and Canada – and not Asia. At the same time, the downward pressure on rates will act as additional policy accommodation.
Third, the market developments have implications for any tightening of US short-term rates. If the Fed opts to act – whether in September or later – there will clearly be an upward move in short-term rates, which David Kotok has recently argued should take place. But what this rate increase will do is stimulate a carry trade by non-US banks that can borrow at essentially zero from their central bank and earn a higher return in the US, and then make money on the round trip to the extent that the dollar continues to appreciate. Again, the inflow of funds will put upward pressure on the dollar and downward pressure on US interest rates, especially longer-term rates. While the short end of the curve may move up slightly, the overall effect will be a flattening and perhaps even a slight decline in longer-term rates. So a tightening move by the Fed would result, for the short term, in a de facto increase in policy accommodation due to the response of international markets.
The interesting implication is that it really matters little in the short run whether the Fed acts or not. In either case, policy becomes effectively more accommodative as the result of international fund flows and not because of what the Fed does or doesn’t do.