Now that last week’s announcements by the “big three” central banks are out of the way, some macro traders expect a relief rally in risk assets, including emerging market currencies and bond spreads that have been in crisis mode since April.
Optimists think they now know the worst of the news from the US Federal Reserve, for 2018 at least, while both the European Central Bank and the Bank of Japan will remain dovish until core inflation rises in these economies.
So is the worst over for EM assets? It did not seem that way as Argentina and Turkey continued to plummet in the strong dollar environment on Friday. And the Fed is turning more hawkish as it wakes up to the effects of the US fiscal stimulus.
It is hard to explain the timing of the EM meltdown with any precision. The newsflow about US president Donald Trump’s intended protection against China and Nafta intensified in April, which cannot have helped. However, protection is not a sufficient explanation, since the Asian economies that will probably be hit hardest by US trade controls have performed much better than other EM assets since then.
Another explanation is that idiosyncratic bad news was released in several big economies in April, notably Turkey, Brazil and Argentina, undermining confidence in their bonds and currencies. But that does not explain why other countries with stronger fundamentals, such as South Africa, became almost equally embroiled in the debacle.
Instead, the change in the market’s assessment of Fed policy and the consequent rise in the dollar has surely been central. It is clear from the important work of Silvia Miranda-Agrippino and Hélène Rey that a rising dollar, following an unexpected tightening in US monetary policy, is bad for all risk assets, especially those in the EMs.
The dollar started to rise in April after prolonged weakness. There are two (admittedly debatable) reasons for this: the realisation that US fiscal stimulus is likely to have large and persistent effects on demand and supply in the country’s economy; and the failure of eurozone activity data to bounce back after the first quarter, causing weakness in the euro. There are obvious problems with both these suggestions, especially in terms of exact timing, but together they can explain the reversal in the dollar and the decline in EM asset prices.
One more factor was crucial. Unlike in previous EM financial crises (such as 2013 and 2015-16), the Chinese economy was robust in April 2018, People’s Bank of China monetary policy was easing and there were no reasons to fear a deliberate devaluation of the renminbi. With China in good shape, Asian EMs have emerged almost unscathed from the recent episode. See Robin Brooks on Twitter:
If the latest outbreak of trade hostility between the US and China gets a lot worse, Asian EM assets might get dragged into the crisis. But the most probable cause of further prolonged EM weakness stems, as usual, from US fiscal and monetary policy.
Reserve Bank of India governor Urjit Patel caused a stir when he warned in the Financial Times on June 3 that a global dollar shortage could develop as the financing of the US budget deficit absorbed foreign savings.
On top of this, he claimed that the planned shrinkage of the Fed’s balance sheet would suck further dollar liquidity out of the global financial system, leaving EM economies scrambling to roll over their dollar debt as capital flows back into the US Treasuries market. This has already started, causing recent EM strains.
Furthermore, in the next 18 months, the funding of the huge budget deficit will require new bond issuance of about $1.8tn, while the shrinkage of the central bank balance sheet will absorb a further $1tn of dollar liquidity as the private sector is forced to refinance redemptions of bonds previously held by the Fed.
Dislocations, and maybe bankruptcies, do seem possible as EM economies raise interest rate spreads on dollar debt to compete with a surge in American credit. Mr Patel says that the “giant sucking sound” of capital flowing into America will be accompanied by a sudden stop in the world economy, unless the Fed abandons its plans to reverse quantitative easing by shrinking its balance sheet.
The Fed itself has little sympathy for these arguments. Chairman Jay Powell has said explicitly that policy tightening by the Federal Open Market Committee has been carefully signalled in advance, implying that the consequences of the Fed’s expected future actions on interest rates and asset prices are already visible in the markets.
This reassuring view is influenced by the Fed’s strong beliefs about how QE, and therefore its reversal, should be expected to affect markets. Based on considerable research (see Claudio Borio and Anna Zabai, BIS), they believe in the “stock” view of QE, under which the full impact on interest rates of Fed bond transactions is observed quickly after the announcement of a policy change, with very little subsequent effect when the flows are implemented in the markets.
If the Fed’s view is correct, the EM financial crisis is likely to end when forward-looking global asset markets have fully “priced” the change in US fiscal policy, along with the Fed’s balance sheet and interest rates. It is conceivable that this has already happened, but the tilt towards hawkishness seen in the chairman’s press conference last Wednesday suggests there could be further surprises to come.
In particular, Mr Powell was much more explicit than before about the impact of the Republicans’ fiscal stimulus on the economy. He said that the impact on demand would be significant and prolonged, that there could be some beneficial effects on productivity and that equilibrium interest rates (r*) could rise as a result. On balance, that combination would support the dollar and prove damaging for EM assets.
To misquote Yogi Berra, it ain’t over till the Fed’s over.