Markets appear to be having a bit of difficulty navigating the end of QE; as the Fed balance sheet starts to shrink, non-US markets in particular are feeling the strain.
The Indian Central Bank Governor recently (in June) warned (quite presciently in fact), that the combined effect of a shrinking Fed balance sheet (i.e. quantitative tightening) AND the sharp rise in the US Budget deficit, has led to a sharp reduction in the global availability of US Dollars, which means big trouble for Emerging Markets (EM) as they are hugely reliant on US dollar funding. The response has been almost immediate. Aside from the well-publicised crisis in Turkey, the South African rand, the Argentinian and Mexican peso, the Brazilian real all fell sharply, taking down their respective bond and equity markets with them.
(Below is a composite Index of major EM currency returns in the last month or so).
This should not come as a complete surprise- we know that many of the emerging economies are not structurally sound and have survived primarily due to the Fed’s previous low interest rate policies. Both capital and risk budgets have thus been misallocated, but as the liquidity tide recedes, this process goes into reverse. Emerging markets assets are cheap, versus their developed market cousins, but for a reason- they are riskier!
Issuing debt in dollars (most EM countries would prefer to issue it in their domestic currency, but most investors literally won’t buy it), means that those debtors are now effectively short the US dollar, (as they need dollars to pay back the principal on their previously issued bonds) and so a rise in the dollar (for whatever reason) involuntarily tightens liquidity for those nations. The more one owes in dollars, the more a rise in the currency hurts. And at the moment it is hurting quite a bit!
But there is a larger potential problem lurking unseen by prying eyes- Asian (both emerging and developed) economies are at even greater risk than even Turkey – at least from a creditors perspective. According to the BIS, (the Bank for International Settlements, the central bankers central bank), total USD debt in Asia (including China) currently amounts to $2.6 trillion as of early 2018, “only” $500 billion of which is Chinese. (Argentina, Brazil and Turkey have around $490 billion between them). Unlike in 1997/98, when the last Asian debt crisis exploded, they now mostly have floating exchange rates, which leaves them more vulnerable to a dollar shortage (which would manifest itself in a higher USD). Furthermore, 28% of the MSCI EM Index is now represented by technology shares (think Tencent, TSNC in Taiwan and Samsung), which might mean that at the very time that they are scrambling to service their huge debt loads, demand might be falling as a consequence of the effect of a rising dollar on global growth prospects. Asian central banks may be faced with the choice of raising interest rates to contain capital flight (thereby causing a recession or worse) or watching asset prices collapse as (mainly foreign) investors depart in droves.
Donald Trump (DJT), however, is doing his bit for EM; he has recently been quoted as voicing his displeasure at the strong dollar, complaining that Jerome Powell, (the Fed Chairman) should not be raising rates, which has of late led to some selling of the dollar. Just ahead of the annual Jackson Hole meeting (attended by the great and the good of Central banking), it appears to be a clear attempt to “lean” on the Fed. Whether it will work, or whether it should is currently up for grabs. Either way, the Fed is damned – risk being seen as lacking in policy independence or continue to raise interest rates and potentially crush foreign asset markets, which could lead to contagion effects hitting US equities and bonds, as sellers sell what they can, not what they want to. The Fed minutes (released last week), suggest that they are going to continue to raise rates, which will presumably set off another firestorm of tweets from DJT. The dilemma is that US core inflation is still running at 2.4% per annum, well above the 2% target (and likely to rise higher if Tariffs are imposed as threatened), whilst the Fed balance sheet has only contracted from around $4.5 trillion at the peak to around $4.3 trillion now and Reserve Balances in the US financial system are still over $2 trillion.
What it all means is that the market’s expectations vis-à-vis full balance sheet reduction are potentially wide of the mark. At current rates of reduction ($395 billion in 2018 and a further $470 billion in 2019), the market currently believes that the Fed will have slimmed down its assets to $3 trillion by early 2021. But if market tensions are this extreme with the process only having just got started, this may prove over-pessimistic (or optimistic, depending on one’s viewpoint). The last thing that Trump’s re-election campaign needs going into 2020 is a sharp drop in the US stock market and so a re-expansion of the balance sheet (and even QE4) may be deemed necessary should this come to pass. Severe domestic (equity market) stress caused by a large US dollar appreciation would leave the Fed, Donald Trump (and Central Bankers the world over), back on the same page and back in “crisis management” mode. We are not there yet, but we could soon be, which would likely be good news for equity owners, but extremely bad news for the legions of Hedge funds, who are currently sitting on all time high US Treasury bond short positions, which they will have therefore to buy back.
Whilst the dollar remains the world’s reserve currency and most of the world borrows in dollars, it will remain the dominant currency unit. Changes in the supply of dollars, (since demand is relatively constant), will in turn decide the fate of global asset prices, so what happens next will be a function of the dollar’s moves. Keep a watchful eye on its price (via the US Dollar Index) and observe the transmission effects via the chart below.
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at firstname.lastname@example.org.
The views expressed in this article are the author’s own and not necessarily those of EBI Portfolios Ltd.
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