The Fed Fund Rate Hike ...Emerging Markets Asset Prices on the Brink?

Following the conclusion of the last meeting of the US Federal Reserves (the Fed) for the year on Wednesday 16th December 2015, in line with market expectation, the Fed Chair (Mrs. Janet Yellen) announced an increase in the Fed-Fund rate to 0.25%-0.50% from the previous 0.0%-0.25%. This came after about a decade of near-zero interest rate environment in the US; a decision taken as a measure to revive the US economy following the devastating effect of the global financial crisis in 2007. With proper forward guidance and expectation management by the Fed, market reaction to the announcement was stable as the decision had been priced into the market ahead of the decision. Thus, immediate impact of the Fed's action across global markets was subdued. However, the emerging and frontier markets are likely to bear the brunt of the action going forward. In relation to the Nigerian financial market, we highlight some of the possible effects of the rate hike.

1.     A higher interest rate environment presents the US economy as a more viable investment destination relative to commodity dependent emerging market economies in an era of lower commodity prices. Thus, we expect a reduced flow of funds towards emerging and frontier markets including Nigeria in 2016. Our view is further buttressed by weaker macroeconomic fundamentals in these markets given the significant plunge in commodity prices in the last 15 months.

2.     Prior to the Fed-Fund rate hike, restriction on FX by the Central Bank of Nigeria (CBN) has constrained market activities, fuelled higher inflation rate and depressed output growth in Nigeria. While official and interbank market rate steadied at N197.00/US$ to N199.10/US$, parallel market rate has depreciated to N280/US$ in December 2015. Increased flow of fund towards the US economy due to higher rate environment points to a stronger dollar. Therefore, another scenario is a further loss in the value of the domestic currency (Naira) against the dollar. We perceive the stability portrayed by the Apex Bank in terms of the official rate which has been kept at N197.00 as contrived, given the significant (N80.0/US$) spread to parallel market rate (N280.00). Consequently, we expect the pressure on the CBN to devalue to intensify as dollar receipts to government treasury continue to shrink in Naira terms while current account deficit worsens.

3.     Finally, higher interest rate in the US and a stronger dollar will increase cost of foreign debt. The recently released Medium Term Expenditure Framework (MTEF) for 2016 shows that fiscal arm is budgeting an expansionary 2016 with a total budget of N6.08tn relative to N4.48tn in the 2015 budget. Consequently, the budget deficit is expected to rise from N1.04tn in 2015 to N2.19tn and foreign borrowing is budgeted to account for about 29.0% (N635.88bn) of the total financing for the deficit. Following the Fed decision, the cost of borrowing for the government, is expected to rise. Furthermore, the cost of servicing FGN and Corporate Eurobond worth US$6.2bn (US$2.5bn & US$3.7bn) is expected to hike as a result of stronger dollar and weaker naira.

Notwithstanding the anticipated impact as noted above, the short term impact in Nigeria is expected to stay muted given that macroeconomic concerns in the domestic economy had already forced market actors to adjust ahead of the announcement.