International credit channel - the Fed matters

The action of the Fed to increase rates cannot be thought of in isolation. The dollar is the key funding currency for cross-border credit. Any action to raise rates will have spill-over effects to the rest of the world. The US will export its policies to the rest of the world.

The international credit channel is critical for global growth and asset performance Investors need to think about the implications of any US action on the cost and availability of credit. Helene Rey gave the recent Mundell-Fleming Lecture at the IMF and presented research on how the global credit markets are connected. (The charts are from her presentation.) There is a global financial cycle which is affected by common factors. For example,  a shock to risk such as an increase in the VIX "fear index" will have a strong impact on cross border lending and pricing.

Rey also finds that the global credit is related to shocks in the Fed funds rate. If you just look at the size of dollar funding, this should not be surprising. A Fed funds shock will increase global risk premiums, have a negative impact on asset prices, increase volatility, decrease leverage, and cut global credit. The impact is across all markets and is sizable.

The Fed cannot think only about what is happening in the US when it take an action. Similarly, investors have to be prepared for a global fall-out from any Fed actions and the result may not be pretty.