The outcome of the US Fed meeting on June 19, 2013 assumes great importance, since the Fed has finally signalled its intention to taper off its quantitative easing (QE) programme within a few months. The rider that the tapering off is dependent on how supportive the US economy proves to be, is only intended to calm investor nerves, lest investors head for the exit.
Equity, bond and commodity markets sold off sharply in Europe and Asia immediately after Fed announcement.
CHINA AT RISK
China has turned from a driver to a drag on global growth. China's official purchasing managers index (PMI) slipped to 50.1 in June from 50.8 in May, according to data from the National Bureau of Statistics.
The final reading of HSBC PMI, meanwhile, fell to a nine-month low of 48.2, below the flash estimate of 48.3 and down from 49.2 in the previous month. A reading above 50 indicates expanding activity and one below 50 signals contraction.
In my article ‘Slip slidin’ away’ ( Business Line , June 15), I had pointed out that the growing forex reserves in countries like China (forex reserves up from $3,344 billion in August 2008 to $5509 billion in March 12) acts like an increase in money supply that fuels deposits and loans.
If the Fed scales back, the process should inevitably go into reverse. I had mentioned that the risk was greatest in China. The Shanghai Composite Index, since then has fallen significantly and is at a four-and-a-half year low, having entered a bear market.
Chairman Bernanke has emphasised that date of the first rise in the federal funds rate would follow a long time after QE3 ends. The 6.5 per cent unemployment threshold required for this to occur was certainly not to be viewed as an automatic trigger.
The Fed appeared to be unperturbed by the bout of market volatility seen lately. Much of it has come in foreign markets, which are not the Fed’s responsibility. The nominal yield on 10-year US treasuries has risen by 56 bps since early May.
This entire move, and more, has been due to a rise in the real bond yield, while the break-even rate of inflation has fallen fairly sharply.
The rise in the real bond yield is a sign of normalisation in the economy, which had to happen sooner or later.
DEFLATION FEARS
Bernanke famously fears deflation (outright falls in price levels), and previous falls in inflation have prompted expansions of the QE bond purchases.
At present, inflation expectations are falling, core inflation is nearing 1 per cent (the target is 2 per cent) and commodity prices are dropping under the influence of China. This looks like a potential deflationary shock.
An expert on Japan, Bernanke is famously worried that deflation could endanger the economy. Yet he has driven long-term rates up at a point when US inflation is falling, as are inflation expectations, while China’s slowdown is pushing down commodity prices.
The difficulty of an exit is complicated by size of the intervention as well as the fact that economic activity and financial markets are heavily reliant on these support measures.
In the US, it requires a government budget deficit of about $600 billion, augmented by injection of about $1 trillion in liquidity from Fed, to create about $300 billion of growth.
Past experience suggests that bond market might be very sensitive to the first signs that the central bank is losing its enthusiasm for further easing. In 1993-94, and to a lesser extent in 2003, bond yields rose sharply, and equity market fell for a time, on first indication that Fed might be contemplating a directional change.
Japan’s experience with QE tapering in 2006 provides useful guidance.
In March 2006, Bank of Japan (BoJ) announced exit from QE, amid signs that activity was accelerating and the economy was emerging from deflation. BoJ exit provides interesting insights regarding what one may expect from Fed in the coming quarters.
During the quarters around the end of QE, 10 year Japanese Government Bond (JGB) yields increased by almost 100bp; from 1.1 per cent at mid-2005 to 2.0 per cent in May 2006.
The Nikkei declined by 20 per cent between April and June 2006 after having increased by 60 per cent in the preceding 12 months. The sell-off was nonetheless short lived.
The exit from QE in Japan was conducted in just 3-4 months, mainly by reducing the amount of bills purchased from private banks, i.e. the most flexible asset on the BoJ (Bank of Japan)’s balance sheet.
Holdings of longer-term JGBs were reduced very slowly and moderately; BoJ actually kept in place its regular purchases of longer-term JGBs. The BoJ also implemented liquidity operations to ensure stability of interbank money markets.
The Fed’s asset-purchase programme has fuelled liquidity in global markets in recent years and some of the extra cash made its way into emerging markets. Countries like India, which have huge current deficits (CAD), have been one of the biggest recipients of equity investment in emerging markets, attracting $67 billion of inflows since January 2010, more than in the previous decade. That is now under pressure.
Emerging markets
A resurgent dollar could lead to import-induced inflation and deter RBI from cutting interest rates aggressively, in a bid to spur growth.
The Indian rupee has fallen 10 per cent. That is not enough, because the calculations on the inflation-adjusted value of the rupee are deceptive -- the Reserve Bank of India takes the wholesale price index for India and consumer price indices for other countries, when everyone knows that consumer prices have been rising faster.
India has one of the largest trade deficits in the world, in relation to its GDP. Last month, India’s deficit in goods trade was twice Japan’s -- which has a three times bigger economy, and which nevertheless is pushing to weaken the yen. Instead of getting alarmed about where the rupee has fallen, we should be looking for it to fall some more, so as to enable India to remain export-competitive.
So a properly inflation-adjusted value for the rupee, using the consumer price index for India too, would take the currency to Rs 63-64 levels.
As Egypt faced massive demonstrations on June 30 and unrest simmers in Brazil and Turkey, we could be in for another “season of discontent” as tensions reach boiling point in countries including China and France.
Revolution in the air
Brazil has faced almost two weeks of protests as its citizens demand an end to corruption and vent their anger at spending on the soccer World Cup and poor public services.
Revolution is not in the air, but dissent is among the ranks. Look at South Africa where the ANC has been in power for 19 years and has failed to deliver what it promised such as alleviating poverty, boost employment and improve education.
In Turkey and Brazil, people have grown increasingly fed up with the governments failing to deliver what they've promised and seeming to have an autocratic rule. So, we can see possible market-moving civil unrest in the short to medium term. Argentina. China, Egypt, India, Indonesia, Malaysia, Russia, South Africa, Thailand, Venezuela are among the countries which could be at risk.
In my article ‘Irrational exuberance is back’ ( Business Line , April 26) written in the backdrop of an extremely buoyant global stock market environment, I had pointed out the reasons why I believed that global stocks were not reflecting true fundamentals. I concluded my article by stating ‘Global stock markets are displaying irrational exuberance and a sharp correction is clearly on the cards’.
Shortly thereafter, we have seen a wave of selling commencing with emerging markets at the front and now we could see the cheerleader-till-now Dow Jones leading the way down over the next few months.
Barring minor pullbacks, we are likely to see a tremendous wave of selling across global stock markets over the next few months.
The author is CEO, Global Money Investor.