Fed to emerging markets: 'Our currency, your problem' – for now
The Fed added insult to emerging-market injury when it failed to acknowledge the EM rout this week, confirming the resolutely domestic focus of its monetary stance despite the international spill-over effects. The move reignites the debate about global monetary co-ordination.
The rollercoaster in emerging-market (EM) asset prices gathered yet-more steam on Wednesday and Thursday, even as the South African Reserve Bank hiked rates – despite Nomura being one of the few shops to forecast tightening, and only from May.
The market consensus suddenly decreed the newfound hawkish monetary stance of EM deficit nations won’t be enough to engineer a correction in current accounts in a timely fashion and attract inflows akin to the pre-tapering QE party.
In a game of monetary chicken – dangerous given the real-economy fallout from pro-cyclical monetary tightening – local currencies, across the board, have fallen over the past month. Meanwhile, EM equities have entered bear-market territory.
Compare these charts then...
... with the Fed’s statement delivered on Wednesday, which announced the unanimous decision to taper QE by another $10 billion to $65 billion per month.
Notice anything? There was not a single mention of EMs.
In other words, then US Treasury secretary John Connally’s statement to European counterparts in the early 1970s about policy spillovers – “our currency, your problem” – today applies to EMs most dramatically, which are grappling with the fallout of the Fed’s reduction in liquidity.
As Ed Yardeni, of the eponymous research outfit, says: “The message to emerging economies in yesterday’s FOMC statement was: ‘Vaya con Dios.’ Of course, that phrase did not appear in the statement. Rather, it was implied when the recent crisis among several emerging economies wasn’t mentioned at all.
“In other words: ‘We wish you well, but your problems aren’t our problem. So there’s no reason to suggest that your crisis is having any impact on US monetary policy.’”
The stakes are high because the pro-cyclical nature of US monetary tightening – QE when EMs don’t need it and vice-versa – has never been so stark.
Fed policies continue to drive the global monetary cycle. Consider the following selective slew of facts:
1. Despite the sophistication of EM central banks – and deeper bond/repo markets, which, in theory, allows policymakers to shape domestic credit conditions with ever-more effective policy tools – the following chart lays bare the master-slave relationship between the Fed and EMs.
2. For the past decade, the US exchange rate has shaped EMs’ investment prospects, with a weak dollar, indicating a loose Fed policy, feeding the global money supply and reducing the cost of funding for carry trades and portfolio shifts to higher-yielding bond, equity and currency markets, while boosting commodity prices, a boon for EM exporters.
The correlation between the nominal US dollar trade-weighted index against global risk and EM flows between 2005 and 2010 is striking, as chart 5 lays bare:
3. A January 2013 research paper by the Federal Reserve Bank of New York concluded a 10-basis-point reduction in long-term US Treasury yields results in a 0.4-percentage-point increase in the foreign ownership share of EM debt, in turn reducing local government yields by 1.7%, across the board.
4. An October 2010 ECB study discovered that between 2002 and mid-2007, EM sovereign CDS spreads and volatility moved in tandem with shifts in the Federal Funds target-rate and, crucially, FOMC communications. In other words, even in non-crisis periods, the researchers concluded that daily and monthly spreads for EM sovereigns are related more to Fed moves than country-specific factors.
5. And in the post-crisis world, EM corporate bonds have been highly correlated with the Fed low-rates party:
Source: UBS Chief Investment Office
And yet the Fed does not give a damn about EMs. Says Yardeni: “The Fed has a very long history of focusing exclusively on the developments in the US. And in Fed working papers, you will hardly find much on emerging markets at all, which is expected if your bosses tell you that they don’t matter.”
However, should the Fed care about the EM slowdown with respect to its inflation/employment mandate? As Euromoney has reported, the finance minister of Singapore thinks so, but most economists disagree.
Says Yardeni, the former chief economist at Deutsche Bank: “US growth did just fine in the 90s. And it was not long ago since Brazil accused the Fed of ‘currency wars’ by keeping liquidity conditions too loose.”
Although he accepts the Fed is directly responsible for blowing EM bubbles, it’s a fact of life all countries will have to accept. If EMs suffer a growth slowdown, which reduces US exports of goods and services, this only accounts for 14% of the US economy, which is heavily domestic consumption-driven at 70% of GDP.
In fact, maybe the Fed is throwing EMs under the bus because that would boost the US real economy? Lower commodity prices, associated with an EM slowdown, would boost US consumers and non-commodity focused businesses, says Shweta Singh, economist at Lombard Street Research.
“The feedback loop is the other way around, in my view,” she says. “In fact, EM weakness will be supportive of US real assets and DM assets in general.”
That said, Yardeni fears in the coming months EM woes might temper Fed tapering as the subsequent relative strength of the dollar “could push US inflation closer to zero”, compared with its 2% target.
In fact, the EM rout might have had an impact on US inflation expectations, given the drop in the US 10-year note, reducing by 17bp during the past three weeks the benchmark’s implicit expected inflation rate to 2.1%.
In any case, market strategists reckon the great rotation – from DM to EM – will still continue.
To sum up, an ugly word characterizes global monetary cycles: asynchronicity. US economic cycles are diverging and US monetary policy is now less suitable for EMs. Most bulls reckon most EMs can offset the pressure thanks to their war-chest of reserves and flexible exchange rates.
However, deficit nations are in the firing line and weak EM investor sentiment shouldn’t be under-estimated.