Indonesian Strategy:Why a 25bp Fed hike doesn’t matter

Event.

The Fed’s decision late last week to postpone its long-anticipated and muchdebatedfirst rate hike was greeted with minimal jubilation in EM stock andcurrency markets, including Indonesia’s, with the JCI closing broadly flat onFriday, while the rupiah actually weakened intra-day (although closedmodestly stronger at the end of the session aided by continuing BI support).

We believe this muted or even slightly negative reaction is rational, becausewe believe a 25bp hike – in isolation – will make relatively little difference tothe EM liquidity outlook. Instead, what we believe matters far more is whether(1) any market perception arises that the Fed has gotten ‘behind the curve’,which would risk forcing rapid future rate hikes that would be far moredestabilising to EMs such as Indonesia than a slow and cautious tighteningcycle; or (2) the Fed opts to begin a slow unwind of QE by allowing maturingtreasury securities to roll-off without being replaced (which it is yet to do).

Impact.

A 25bp hike off a base of zero is not a big move – particularly when viewed inthe context of the level (9.0%) and recent volatility in Indonesia’s existing 10yrgovernment bond yield. We would argue that what matters is not whether a25bp hike occurs, but what the Fed’s actions imply about the medium to longterm outlook for interest rates, and the risk to EMs like Indonesia is not a 25bphike per se, but rather that rates rise much more than that, and/or rapidly.

The neutral to negative market reaction of EM currencies and stock marketsto the Fed’s announcement therefore appears rational, as it likely reflects abelief that by continuing to defer rate increases, the Fed is increasing the riskof being (or being seen to have become) behind the curve. The Fed gettingbehind the curve would likely have profoundly negative consequences for EMasset prices and liquidity far in excess of a proactive ahead-of-the-curve 25bp.

We also believe the liquidity risk to Indonesia should the Fed ever move tounwind QE by shrinking its balance sheet is a much greater risk than the Fedmaking modest rate hikes. Since late 2013/early 2014, the Fed halted theexpansion of its balance sheet (which triggered the so-called ‘taper tantrum’),but continued to buy securities to replace maturing securities, and therebysustain the pre-existing liquidity support. The resultant EM turmoil to date hasoccurred merely by virtue of the Fed ceasing to add more liquidity. If the Fedstarts to slowly drain liquidity, this impact will likely intensify significantly.

We believe the impact of Fed money creation via QE has been as if not moreimportant to EM liquidity than low rates. The Fed’s QE programme wasintended to stimulate economic activity in the US (and inflation), but largelyfailed to do so because the funds instead wound up in the central bank vaultsof EMs. This triggered a wave of money-printing in EMs (and did stimulateeconomic activity and inflation in these markets). If this process goes intoreverse, the impact on EM economies and asset prices could be material.

Outlook.

The outlook for liquidity will remain, as ever, uncertain. However, pressure onthe rupiah is considerable, and is unlikely to abate by virtue of the Fed’s ratehike deferral. If this pressure persists, it is likely to add to pressure ondomestic activity and asset prices.