The global capital markets imploded in the second half of last week and investors spent the weekend contemplating the significance. The main focus was on the emerging markets, which were especially hard hit. American-firsters (the tendency on the political right and left to blame the US first for all the undesirable things that happen in the world) jumped at the opportunity. Even in the Financial Times, which acknowledged other factors at work deemed worthy of a call out that the “Exit of money from Argentina has been driven by renewed concern about the US Fed.” Really?
The concern ostensibly is that the Fed is going to proceed with its tapering strategy announced last month. As the Fed reduces its yield compression efforts (QE), interest rates are expected to rise and making those emerging market countries reliant on foreign capital inflows (current account deficit countries) particularly vulnerable. We have seen this in the recent past. Emerging market crisis have often happened when the Fed tightened. It is happening again. Q.E.D. Any further analysis has been rendered superfluous.
Rather than deduce the recent crisis from such rules, a quick reality check suggests a far more complicated picture.Moreover, the fact of the matter is the US interest rates have fallen, not increased, so far this year. Since peaking near 3.05% at the very start of the month, the US 10-year yield slipped 20-25 bp even before the equity market slide in the second half of last week. The short-end of the curve has been steadier, with the 2-year yield off about 4 bp this month. The short-dated T-bills have come under some pressure amid increased anxiety over the debt ceiling deadline and discordant rhetoric from Washington.
There are two levels of analysis that are relevant in a proper analysis: international and national. The international level of analysis would note other forces besides the Fed tapering. Four are in fact readily apparent. Two of them relate to China.
First, the HSBC flash manufacturing PMI was below the 50 boom/bust level, warning that economy is still slowing. Many emerging markets have grown on the back of China’s growth. Brazil and South Africa, for example, appear particularly sensitive to such a development. Second, there is heightened fear that China may accept the failure of a wealth management product that is thought to expire at the end of the month, just before the Lunar New Year, which is also absorbing liquidity.
Some fear a slippery slope, where one failure would be the spark panic in a situation fraught with moral hazard. Wealth management products appeared to offer investors significantly higher short-term yield than available in the market and seemingly guaranteed by the big bank distributors.
The third international pressure on emerging markets came from pressure to unwind yen (and to some extent Swiss franc) cross positions. Many leveraged participants were using the yen as a financing currency to fund the purchase of some emerging markets. As the Commitment of Traders report from the CME currency futures show, the short yen position was extreme. Ironically, the decline in US Treasury yields may have helped spark the yen short squeeze that forcing players out of the long end of the position.
The fourth international factor involves the increasing reliance of central banks on forward guidance. Comments by BOE Governor Carney and one of the acknowledged innovators of forward guidance, suggested that it was GTC (good-til-close). Some saw in Carney’s comments an abandonment of forward guidance. Contagion was a word thrown around last week in terms of price action, but questions raised by Carney’s comments put the Fed’s forward guidance under question as well. It seemingly removed an anchor of monetary policy.
We have argued that the confidence of the Fed’s forward guidance was on fragile footing. First, it was announced by a Fed chairman that was not going to implement it. Second, Obama and Bernanke have done nearly everything one would advise if one wanted to prevent Yellen from exerting strong leadership: have her predecessor lay out, in some detail, the path of the Fed for the next year; do not have Bernanke resign upon Yellen’s confirmation; and nominate as the vice-chairman a person whose track record of accomplishments and experience cannot help buy overshadow the Yellen.
After Obama’s first choice to succeed Bernanke (Summers) was not successful, the President had little choice but to accept Yellen. His reluctance seems painfully obvious and we suspect to the detriment of investor confidence.
We have argued that forward guidance is a communication style that is simply being emphasized now, as central banks (except for the BOJ) move away from unorthodox policies. Just as the Fed tried, initially with little success, to convince investors that tapering was not tightening, so too officials will have to help investors appreciate the difference between thresholds and triggers.
The threshold has been approached in the UK. In effect, Carney said, “Yes, the unemployment is near the threshold we identified. We have reviewed the situation and have decided that it will still be some time before we think we will need to raise interest rates.” The lack of wage pressure suggests plenty of slack still in the labor market.
Yet one would be remiss if the analysis stops with these factors without considering the national level. Indeed, when looking what is happening in several countries, the international factors look relatively minor. Surely, one cannot ignore the domestic developments in Ukraine and Thailand for example. Argentina, without much good will among investors, lost more confidence, not because the Fed tapering or China challenges, but because the President replaced her economic team in November and still has failed to rein in the large current account deficit or deal with the near 25% officially recognized inflation. Last week the central bank stopped throwing its reserves away (losing a third over the past year). Even with the peso’s decline, it is still well above the black market rate.
Look at Turkey. The political leadership is struggling as two Islamic factions clash. Turkey has a current account deficit of 7.5% and inflation around 7.5% as well. Seemingly due to political pressure, Turkey’s central bank refused to hike the overnight lending rate, which at 7.75%, is barely positive. Turkish reserves are only a little higher than Argentina’s.
This is not meant to be exhaustive, just suggestive of the role that national developments played last week in the meltdown seen in many emerging markets. We note that China’s shares were the best performer, with the Shanghai Composite up 2.5% and the smaller-cap Shenzhen Composite up a little more than 5%. Equities also advanced in Taiwan, India, Thailand and Indonesia. According to data Bloomberg receives from the local stock exchanges, India, Indonesia, Philippines and especially Taiwan saw net foreign purchases last week.
Some emerging markets have made significant strides in the past decade or two. Others have benefited more from a rising tide of liquidity. We suspect that many investors exaggerate the structural reforms and minimize the role of liquidity. Emerging markets, as an asset class, have been under-performing for months. The acceleration last week seems largely a result of local events and position adjustment rather than higher US interest rates. We believe that the doubts over forward guidance in the UK and US are in the direction of keeping policy looser for longer, not in tightening sooner.
There are many events and economic reports due in the week ahead that could capture the imagination of market participants, though the directive of preserving capital may be dominant. The increased volatility may encourage participants to wait for the event risk to pass before re-engaging. A number of emerging market central banks meet, (India, Malaysia, Israel, South Africa, Colombia, and Mexico), but no policy changes are expected.
There are two highlights for the US. The first is the FOMC meeting that concludes Wednesday, without a press conference. We suspect the risk of lowering the 6.5% unemployment threshold is minor compared with the likelihood that it will underscore that rates will remain low until unemployment is well below that threshold. We expect it to continue to taper, reducing its asset purchases in February to $65 bln. This still seems significant and about 50% larger than QE3 before Operation Twist’s purchases were rolled into it.
Second, the US reports its first estimate of Q4 GDP the following day. The second half of last year was particularly strong for the US and a 3-handle on Q4 GDP seems a reasonable bet. And that is with inventories accumulation acting like a modest drag on growth. Final sales then could be in the 3.5-4.0% area. Growth is expected to slow here in Q1, partly weather induced.
Turning to the euro area, we expect this week’s data to help stabilize deflationary fears and argue against the ECB unveiling any new initiative next month. We have argued that disinflation, and even deflation, in the periphery is seen by many officials as necessary and evidence of an internal devaluation that will boost competitiveness. Money supply in the euro area is expected to have ticked up in December from 1.5% to 1.7%. It is still too low, but the lack of fresh declines means that the urgency to act may wane. Similarly, the preliminary January CPI may also show a small increase (0.9% year-over-year from 0.8%), confirming no further deterioration. The December unemployment rate may have remained steady (12.1%).
The UK reports its initial estimate of Q4 GDP on Tuesday. The recovery of the UK economy in 2013 was one of the biggest pleasant surprises of the year. It is expected to have finished the year in good form, expanding around 0.8% on the quarter. The risk may be slightly on the downside, due to construction. Separately, BOE Governor Carney has promised an update on forward guidance with the quarterly inflation report on February 12, before which there will be another round of CBI/PMI reports.
This piece is cross-posted from Marc to Market with permission.