On: March 31, 2022 In: Blog, Fixed Income, Knowledge Centre

By Dr Ray Choy, Head of Economics & Research

Nothing is permanent

The US Federal Reserve (Fed) has vacillated between inflation denial to inflation aggression over the last few months, first beginning with the idea that inflation will be “transitory” in the early months of 2021, and subsequently abandoned that notion before the end of 2021. Technically, no individual macroeconomic factor has proven to be permanent, nor can we expect that of the Federal Reserve’s call on inflation and its view of the interest rate pathway. Therefore, even as notions of inflation have turned less amiable, it would not be surprising if the narrative on combating inflation reversed course in the second half of 2022.

In fact, the idea that inflation will eventually decline from mid-2022 onwards has not changed much within the forecasting community. Furthermore, the sharp spike in commodities prices due to the Russia-Ukraine war creates the mathematical dynamic where inflation is currently at a very high base, which means that it takes little for inflation to moderate going forward into the second half of 2022. Essentially, there is no incentive for Russia, Ukraine and all other parties caught up in the geopolitical nexus for the war to stay protracted. Once there are signs of the war ending, commodity prices will inevitably decline. Ultimately, the end game to this war is for a swift resolution without further escalation, even if it means compromises to the extent of Ukraine’s sovereignty.


US interest rate policy expectations remain aggressive

At present, the US Federal Reserve expects the interest rate to rise to 2% by end-2022, and potentially 2.5% by 2023. Apart from higher interest rates to the tune of six more rate hikes this year, would be the Fed’s schedule to reduce its holdings of US Treasuries. The residual risk of the schedule depends on the size of its balance sheet reduction, the speed of this process, and whether the Fed communicates expectations clearly without deviating from its intended plan.

Against this backdrop, US Treasury yields have turned up, breaking past a multi-decade trendline of declining yields.  The bad news is, markets will continue to price these forward expectations in the short term, even though the interest rate pathway will require more than a year to evolve. This creates a clustering of higher bond yields and negative expectations in the first half of 2022. The good news will arrive subsequently, as markets will be pricing in peak inflation and peak interest rates in 2022. Assuming the International Monetary Fund (IMF) and most forecasters are correct, the peak would likely occur by mid-year and at worst, not continue beyond 2022. The difficulty in timing this forecast would be attributable to when the war would end, and whether the ongoing and war-amplified supply chain disruptions adjust to normalcy soon enough.


The consequences of aggressive interest rate policy

A major consequence of higher interest rates would be slower growth, and at the rate the Fed intends to progress, the risk of a US recession is increasing. The global growth prospect does not look bright either, and the IMF in its January update foresees a decline in GDP growth from 5.9% in 2021 to 4.4% in 2022 and to 3.8% in 2023. Further downgrades to growth is to be expected given the Fed’s increasingly aggressive rhetoric to raise interest rates and the Russia-Ukraine War. Even if higher interest rates have yet to happen, the negative effects of weaker sentiment are already being felt on funding markets, raising the risks of funding squeezes globally. At some point in time, this will translate to a decline in investment and consumer spending as higher debt servicing costs erode wealth, liquidity and discretionary income.

Already, the US yield curve is approaching inversion, a traditional indicator of recessions. This is a situation where short term yields are higher than long term yields. The yield curve is now reflecting common factors of recession, namely the commodity price shock, the risk of overtightening by the Fed, and a Black Swan event such as the Russia-Ukraine War. Due to the commodity price shock, on top of recession risk, stagflation risk has increased, where inflation is rising while growth is slowing. Other Black Swan events that could unfold would be the risk of social uprising caused by rising food costs and tightening financial conditions, alongside political upheavals caused by major elections globally in Europe, the US and Asia.


Malaysia’s situation is less dire, bond yields are less correlated to transmission from the US

In a situation of stagflation and recession, few economies will go unscathed but some countries may be less adversely affected than others. In Malaysia’s case, the rise in oil price is expected to improve its trade balance, fiscal balance and gross domestic product (GDP) growth. Other commodities which Malaysia exports, namely palm oil, has also increased significantly. This has reflected an improvement in the external balances of Malaysia which will support currency stability and foreign inflows. Alongside other commodity exporters, Malaysia’s assets will be at an advantage in the global market’s perception as it will benefit from higher oil and commodity prices.

On the other hand, the rising interest rate differential between the US and Malaysia will continue to be a worry where rising interest rates in the US will be viewed as attracting capital away from Malaysia if its interest rate is maintained. However, this is a more theoretical viewpoint than empirical one. Historically, there is a limited correlationship between US Treasury (UST) yields and the yields of Malaysian Government Securities (MGS), in the region of 40% co-movement. In 2021, the transmission between UST and MGS yields was higher partly due to concerns over the sovereign credit rating amid heightened spending during the pandemic. However, since then, the correlationship has declined in 2022 and present yield movements in the MGS market are less volatile as compared to the UST yield curve. This suggests that Malaysian bonds remain as good diversifier in portfolios, and although there will be a short-term reaction to global market volatility, it is likely to outperform other emerging markets. Therefore, while there is further upside risk to Malaysia’s bond yields as global inflation rises through to mid-2022, we see this as less than in the US and other emerging markets. Going forward, by the second half of 2022, we believe the Malaysian bond market will have better prospects and room to improve.

The limited correlationship between Malaysia and US yield curves also suggest that fundamentals are sufficiently different to warrant different economic policies. Firstly, Malaysia’s inflation rate is less than half of the US where it is expected to exceed 8%. Malaysia, being an oil exporter with subsidised fuel and a range of price-controlled items such as basic foodstuffs, will experience well-contained inflation. Interest rate policies in Asia today are no longer as closely tied to the advanced economies.

The actual situation and the narrative on higher interest rates is more mixed than the dominant idea of higher interest rates along the lines of the US story. The fact is, China has already begun cutting interest rates, Australia’s central bank has expressed concerns over the soft labour market, and Thailand has maintained accommodative interest rates with no indication of raising interest rates. Even amongst advanced economies, central banks have divergent views on monetary policy. Japan’s central bank has maintained a policy of purchasing bonds from the market as required to aid the economic recovery despite rising inflation. In Europe, the European Central Bank (ECB) is battling inflation although its economy will be most affected by the Russia-Ukraine war which may lead to a change in stance toward easier monetary policy. Therefore, the mix of economic scenarios and pathways suggest that there is no need for Malaysia’s central bank to raise interest rates aggressively in line with US policy, and Malaysia will probably raise the interest rate by a token 25 basis points in the second half of 2022 given the mild rise in inflation.

Finally, it is important to note that interest rate policy in an emerging market such as Malaysia need not have an overly skewed focus on inflation.  Malaysia is still developing and therefore, it is important for funding conditions to be conducive to growth, especially when the country is recovering from the downturn and pandemic of 2020-2021. Unlike the inflation-targeting, import-heavy advanced economies where preserving currency status is of utmost priority, developing countries would lean towards prioritising growth as compared to inflation targeting.


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