Gulf states are expected to begin a new monetary easing cycle on Wednesday when the US central bank begins cutting interest rates.
The decisions the Fed makes can ripple across economies and markets. In the Gulf, where most currencies are pegged to the US dollar, the Fed's monetary policy decisions are particularly significant.
Gulf central banks have largely followed the Fed's lead since it began its aggressive rate increases in 2022.
When the Fed set its target interest rate range of 5.25 to 5.50 per cent in July 2023, the move was mirrored by most Gulf economies. Saudi Arabia increased its repo rate to 6 per cent, while the UAE and Qatar increased their rates to 5.4 per cent and 6 per cent, respectively.
Because of the dollar peg, the Gulf is sensitive to the Fed's actions and the overall US economic cycle. This was apparent during the 2008 global financial crisis, which began in the US but also reached the Gulf, where economic growth stagnated.
Recession fears briefly resurfaced this summer after a surprising increase in the US unemployment rate.
Markets in the region reacted negatively, leading to a brief equity rout that stretched from Wall Street to Abu Dhabi. Equity markets have almost entirely erased those losses as recession fears eased.
On Wednesday, the Fed is widely expected to reducing interest rates (currently set between 5.25 per cent and 5.50 per cent), with futures markets anticipating an initial cut of 50 basis points. Most Gulf banks are expected to follow.
Dollar peg
Many countries in the Middle East – including the UAE, Saudi Arabia, Qatar and Jordan – peg their currencies to the US for stability because of their need to have the US as a major trading partner.
That means, when the US central banks cuts rates, it will have little impact on trade between it and dollar-pegged countries.
“They move with the Fed to maintain the fixed exchange rate, and so the exchange rate doesn't change,” said Brad Jensen, an economics professor at Georgetown University.
“So it doesn't have much impact, because there's no effective price change,” he said.
economics professor at Georgetown University
Pegging to the dollar also helps Gulf economies control inflation to help mitigate sharp increase in the cost of goods.
Oil prices
As a result of their impact on the US dollar, interest rates also factor into the price of oil.
A stronger US dollar typically means lower oil prices as barrels of oil are priced in US dollars. When the dollar is weak, oil prices typically increase.
Opec members agreed in June to extend their oil production cuts into 2025 given high interest rates, US production and slowing demand growth.
Saudi Energy Minister Prince Abdulaziz bin Salman at the time said members are waiting for interest rates to come down and for a better idea on economic growth.
Last week, the group said it will extend its production cuts of 2.2 million barrels per day through November and will begin phasing out the cuts from December until November 2025.
Brent Crude oil was trading at $72.79 per barrel as of 4pm UAE time Tuesday, down 5.43 per cent this year. West Texas Intermediate was trading at $70.32.
Still, other factors play into the price of oil including geopolitics, supply chain shocks and production.
When the Fed last cut interest rates in 2020 to zero in response to the coronavirus pandemic, oil prices still plummeted. The worldwide demand for oil fell precipitously because the pandemic had restricted travel, which left Brent Crude oil trading at $9.12 per barrel in April.
Gulf banks resilient
Banks, which have enjoyed a period of profitability during the Fed's monetary tightening cycle, are expected to lose some profitability as interest rates come down.
The top 45 banks in the Gulf reported a 10.4 per cent annualised lending growth in the first half this year, stimulated by non-oil sectors in the UAE and Saudi Arabia, according to an S&P Global analysis. That marked an increase from 6.7 per cent last year.
S&P said during that same period, higher-for-longer interest rates kept banks' margins stable at 2.7 per cent.
Outside any unexpected shocks, banks' strength is expected to continue even though rate cuts will bite into some of that profitability.
S&P Global expects the Fed to cut rates by 150 basis points from September 2024 until the end of 2025, which would be likely to shave 12 per cent from banks' profits.
“This is also likely to create some breathing space for highly leveraged corporates and retail clients, thereby supporting asset quality,” S&P Global said in its analysis.
Sebnem Kalemli-Ozcam, an economics professor at Brown University, said rate cuts pose no risks to banks which have stronger balance sheets. While they will make less money on corporate money, those banks can generate revenue on other assets like bonds and equities in a booming economy, she told The National in an email.
S&P Global said banks are still exposed to potential slower economic growth because of dynamics in the oil market, geopolitical risks and unwinding of balances in real estate and other cyclical sectors.
