This article first appeared in The Edge Malaysia Weekly on November 26, 2018 - December 2, 2018

THE US Federal Reserve is probably the most hawkish central bank in the G20. So far this year, it has increased its short-term interest rates three times to 2.25%, and it is likely to implement another quarter percentage point hike on Dec 19.

However, it is not the forecast rate hike at the final Federal Open Market Committee (FOMC) meeting for this year that is being closely monitored by economists and market players, but the Fed’s policy direction for next year.

The rate hikes so far this year have contributed to weakness in emerging market (EM) currencies, including the ringgit. As the global economy is still sluggish, further rate hikes in the US will exert even greater pressure on EM currencies.

Economists and foreign exchange strategists say the smart money is on a continuation of interest rate hikes next year, which is not entirely surprising as the last FOMC meeting guided for an interest rate of 3% in 2019, which is an additional 75 basis points from the current rate.

“The Fed would want to continue to hike, in our view, because its voting members will consider any gross domestic product print around 2% or above sufficient to warrant continued normalisation, especially if core personal consumption expenditure inflation remains around 2%,” says DBS Group Research chief economist Timur Baig in a report last Friday on the outlook for interest rates. “We think both of those outcomes are highly likely next year. Growth will not be as high as seen this year, but that has been considered unsustainable by Fed officials in any case.”

The Singapore-based bank expects the Fed to increase benchmark rates to 3.5% next year from the current 2.25%. While that level may lead to an economic slowdown, or even a recession in 2020, if wages continue to rise, monetary policy will have to remain active, says Baig.

At the last FOMC meeting in September, the Fed had said that it will increase its benchmark rates to 3% in 2019 and 3.5% in 2020, as it believes the US economy is growing smoothly. Its target for the US economy is to grow by 3.1% this year, 2.5% in 2019 and 2% in 2020.

However, as recent US economic data points to much softer economic growth than initially projected, the Fed has been urged to relook its rate hike programme for next year.

Last Wednesday, the US Labor Department reported that jobless claims had increased by 3,000 to 224,000 in the week ended Nov 17, the highest in four months. Meanwhile, orders for durable goods declined 4.4% in October from September, the biggest monthly decline since July 2017.

Sales of the current stock of houses fell 5.1% in October from a year earlier — the largest annual decline since 2014. This drop as well as the 6% fall in the Dow Jones Industrial Average and Standard & Poor’s 500 since Nov 8, underscore that the US economic recovery is still in a nascent stage.

Julia Goh, senior vice-president, global economics and markets research at United Overseas Bank (Malaysia) Bhd, says the bank is currently reviewing its base-case, mid-2019 projection of RM4.22 to the US dollar. She sees further ringgit weakness ahead.

However, US rate increases aside, the ringgit will also shrink if crude oil prices continue to slide and if other regional currencies, especially the yuan, weaken.

The ringgit is seen as a close proxy to the yuan, owing to the large trading volume and value between the two countries. Malaysia is China’s largest trading partner in Southeast Asia while China is Malaysia’s largest globally.

The performance of the ringgit next year will also be influenced by the monetary policy of the People’s Bank of China (PBOC). The bank’s yuan reference rate is inching towards 7.00 yuan to the greenback, with last Friday’s rate at 6.9306 yuan.

So far this year, the ringgit has depreciated 3.28% to 4.192 against the greenback, in line with other regional currencies. The baht fell 3.7% to 33.037 while the Singapore dollar dropped 2.77% to 1.374.

While the ringgit is also influenced by other factors, such as the movement of crude oil prices, Brexit uncertainties and domestic economic issues, the prospect of a stronger US dollar presents the greatest risk to the ringgit shrinking to 4.20 before the year is over, says Jameel Ahmad, global head of currency strategy and market research at FXTM.

“Emerging markets across Asia might not be as exposed to Brexit-associated risks as those situated more closely to the UK and Europe, but it is something that can make investors less attracted to investing in riskier assets.

“It will be interesting to see whether political uncertainty in Europe encourages investors to take the US dollar for another run, which would bring another return of the dollar divergence story that has pressured emerging markets ... throughout large parts of this year,” says Jameel.

The ringgit’s current level has already factored in a more spaced out Fed policy rate normalisation, says Dr Yeah Kim Leng, director of the economic studies programme at the Jeffrey Cheah Institute on Southeast Asia. He believes the ringgit could hold up at the current level until year end, with the resiliency of the local economy being a key factor should global trade tensions increase.

“Besides supportive credit and financial conditions, the gradual pace of price increases next year, to reflect higher fuel prices following the below-trend inflation in 2018, will be conducive for the continuing moderate pace of consumption and investment activities.

“These moderate growth and inflation trends suggest that the domestic factors underpinning the ringgit are expected to remain relatively stable,” he says.

Meanwhile, economist and executive director of SERC Sdn Bhd Lee Heng Guie says  the continuation of the Fed’s rate hikes and the narrowing of the yield gap between the US and Malaysia will enhance the attractiveness of holding US dollar-denominated assets.

“This, along with intensified trade tensions come January, concerns over global growth and further volatility of financial flows will continue to weigh on the ringgit,” says Lee, adding that the ringgit could be trading at  4.15 to 4.20 by year end, and 3.95 to 4.00 by end-2019.

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