Markets continue to focus on the Federal Reserve and how quickly and by how much US interest rates are expected to rise this year. This matters of course for global markets, but it also matters for local ones given the existence of dollar pegs that usually mean that interest rate rises in the US are matched one for one in the GCC. Last week provided some new insights about the Fed’s intentions, but local developments have also been interesting with regard to the gap that usually exists between local interest rates and those in the US.
The minutes of the January Federal Open Market Committee meeting, the last that Janet Yellen chaired, showed that the majority of members felt that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate. The addition of "further" in the accompanying policy statement was interpreted as slightly more "hawkish", especially as the FOMC minutes pre-date the recent congressional agreement to remove spending caps, which means that the overall fiscal stimulus could be even bigger over the next year or so than was assumed at last month's policy meeting. The market implied probability of rate hikes in 2018 still remains at three hikes this year but has now increased from one to one-and-a-half for 2019.
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A subsequent monetary policy report by the Fed released on Friday, which will serve as the basis for new chairman Jerome Powell's congressional testimony on Tuesday, showed little difference with the last thoughts of the Yellen Fed. The report said that activity increased at a solid pace over the second half of 2017 and the labour market continued to strengthen. It also mentioned inflation has remained below target, and added that despite the tight labour market, wage growth has been moderate in part held down by low productivity growth.
In short there was nothing in the report to suggest that the FOMC will alter its gradualist approach to policy normalisation, leaving a March rate hike looking likely, and with more tightening after that.
The interesting development locally is that UAE interest rates, the Emirates interbank offered rate (Eibor), that are normally a small margin above US interest rates, the London interbank offered rate (Libor), are now slightly below them. Though the absolute level of interbank rates in the UAE have risen in line with higher US rates, the spread between three-month Eibor – Libor rates has reduced from a premium of around 213 basis points during the financial crisis in early 2009 to a discount of 6bps now.
In theory, the spread between the interbank rates of pegged currencies should be minimal in a free market. However, in practice, it is frequently not. This is because the ability to arbitrage between the different rates on pegged currencies requires the existence of liquid rates and FX markets. In the GCC the markets are not liquid enough for this arbitrage to be exploited and to then exert pressure on rates to revert to median. Therefore Eibor rates can often reflect local situations rather than mirror exactly the movements in Libor rates.
Usually Eibor trades at a small premium to Libor, reflecting the different dynamics within the region compared to the economic situation in the US. This time, however, Eibor is trading at a discount to Libor due to a number of special factors.
High oil prices are translating into strong revenues for the government, which are sitting on deposits in the banks. At the same time lower economic growth is translating into low credit growth. This combination of strong deposits and low credit growth has resulted in increased liquidity in the local financial system, supported by an influx of foreign funding through new bond issuance, and exerting downward pressure on local interest rates.
Usually such situations, where Eibor rates fall below Libor rates, do not last for long, but given expectations of loan growth remaining lower than deposit growth in the coming year, and given anticipation of more debt issuance, this time it might persist for a bit longer. Against a background of monetary policy normalisation in the US, this is a development that should serve to cushion the impact of rising US interest rates.
Tim Fox is group chief economist & head of research at Emirates NBD