Emerging markets have quickly become submerging markets, and a race to liquidity has sparked widespread sales of assets ranging from US Treasuries to gold. While the media are quick to blame the Fed’s premature signaling of quantitative easing (QE) withdrawals, reality could involve the widespread disenchantment with the abject failure of monetary scheming to restore economic growth. Essentially, credit risk is being repriced into the markets at an inopportune moment.
With no malicious intent and purely for entertainment, I produce below two sample images that describe market happenings over the past couple of months:
One image, of Newton’s cradle against a model of the globe, the cradle is a device that shows off the conservation of energy in physics; the other shows the emblematic moment when the cartoon character Wile E. Coyote runs off yet another cliff chasing the Roadrunner.
In the popular version of events, the Fed is the first ball that sets off global “adjustment” process that in turn causes volatility in the most inflated asset classes – emerging market stocks, long-dated US bonds and even gold, that is, the Wile E. Coyote moment. Call it the QE Coyote moment for global asset managers.
The proximate change in market psychology arose ostensibly from statements issued by the Federal Reserve to the effect that it would begin unwinding the bond-buying programs that were an integral part of the quantitative easing strategy. US Treasuries, particularly longer-dated bonds, fell in price terms (or their yields rose).
That was however not quite the highlight – the more remarkable and focused decimation in fixed income took place elsewhere, in mortgage yields that widened twice as fast as government bonds. The rise in mortgage yields has also caused a rush by dealers to hedge rates, in turn pushing up swap rates. These convexity effects are likely to further accelerate once all the other un-hedged bond investors (pretty much everyone was un-hedged, given the sharp fall in bond yields caused by the Fed’s QE in the first place) start to rush towards the exits, ie attempt to remove interest rate risk from their portfolios.
If this trend goes on for a bit longer though, the effect will be to push out US government borrowing rates higher. With a yawning deficit and no real plan to cut the deficit in coming decades, this rise in borrowing costs could soon become self-feeding: investors will eventually start demanding higher rates as compensation for taking on the credit risk of the US government. You know, the old-fashioned fear of default that is supposed not to exist for government bonds. I believe some folks who purchased Greek government bonds have an opinion on that subject.
Of course, all that is very far away for now. The more immediate question is the disconnect between the Fed’s stated target of when the bond buying program would be withdrawn and the specific data that would drive the process. Bill Gross, the world’s largest private bond manager, commented on this disconnect:
It was a pro-growth type of statement and a suggestion that some additional definitions in terms of when tapering might begin and when it might end. Obviously according to a 7% unemployment number that speaks in his mind and perhaps my mind to early 2014. But I might also say in terms of questions and answers, and that is critical I think, that he did speak to the conditional influence of inflation. That even if unemployment came down to 7% and inflation did not go up to 2%, they would look around and readjust their decision. This is a combined growth, unemployment and inflation type of combination that has to be delicately managed, and I think the market has misinterpreted the growth and the unemployment targets while leaving out the inflation targets going forward.
Just to make clear his views on the quality or lack thereof of the folk selling bonds (and presumably, causing losses in his portfolio), he further explained: “The mistake the Fed is making is blaming lower growth on fiscal austerity and expects towards the end of the year once that is gone, all of a sudden the economy will be growing at 3%,” or more simply the error of their policy-making ways is “to think that is a cyclical as opposed to a structural problem in terms of our economy”. The bottom-line is that Gross sees less taper (due to disinflation) and warns “those who are selling treasuries in anticipation that the Fed will ease out of the market might be disappointed”.
However, the signals appear mixed up, coming as they do just after the Japanese yen reversed its slide, as local investors sold their foreign assets and repatriated money home. This is a strange move, as massive QE by Japan has been held up as the cure to the world’s (documented) economic problems.
A central aspect of this strategy was to make the purchases of Japanese fixed-income assets so unattractive that the average local investor would do crazy things – like, you know purchase stocks, houses and (gasp!) foreign investments. Between the lower (non-existent) bond yields and falling yen, export competitiveness would generate more manufacturing jobs while risk-taking at home would push up asset prices that would in turn augur more risk-taking.
So the normally obedient populace suddenly decides to sell all the fancy foreign stuff and bring their money straight back home. They did this apparently because local bond yields galloped (remember the convexity thing previously – that also pushed up Japanese bond yields sharply).
A poor attempt at structural reforms by a shy Japanese government that apparently didn’t want political risks ahead of upcoming elections was the proximate cause: absence of reforms would render future growth prospects for Japan non-existent, and thereby increase the credit (default) risk of the Japanese government; with rising US bond yields, there was a significant expansion of bond yields in Japan.
Yes, that word again – default. Coming on the back of sharply higher Japanese growth figures, this rise in bond yields was a bit of a head scratcher as it appears to have occurred for the “wrong” reasons, ie not a fear of inflation or a reversal of the Bank of Japan’s QE but rather a rise in long-term credit risks of the country.
China and India
Then there is the blowout in Chinese local borrowing rates. The reason it is confusing is that macro data has been decidedly soft in recent months, particularly on the trade and manufacturing fronts. With an apparent cooling of real estate prices also underway, why then would interbank rates go up?
This one appears structural: despite a banking system that has some of the world’s best deposit-to-asset ratios, a series of restrictions on “shadow banking” – finance by non-bank participants usually in sectors of the economy that are not favored by the government (eg real estate) have helped to create strong demand for bank lending. Essentially, these finance companies borrow from banks and lend to the unsavory sectors.
Government tightening of this leakage from the banking system has been the immediate driver of higher interest rates, with a near 4% expansion in the interbank reference rates putting paid to a number of finance companies and causing severe disruption to asset markets.
Across the Himalayas, the Indian rupee has taken a beating, falling to 60 rupees against the US dollar, having started the year around 53 rupees. Fears of lower economic growth, corruption scandals that have dented foreign investor confidence and failed reform attempts all lie at the heart of the reversal in the Indian currency.
With a mounting import bill and elections next year that would likely increase populist measures by the government, foreign investors did not want to wait around. Lower growth expectations around the world also remove the optionality premiums that countries like India enjoy in their asset prices. Ergo, falling asset prices that cause further falls in the currency.
Then there is gold. The basic argument for gold prices to fall appears to be that QE programs would stop, thereby helping to reduce random money creation and with it, much of the demand for gold. However, as we have seen above, fears of government credit risk appear to be rising not falling at the current juncture, so why then would gold – which usually benefits from situations where government bonds fall due to credit concerns – fall in price now?
Firstly, there is the aspect of funds and individuals selling whatever they can in order to improve their liquidity. Gold in that sense remains attractive. The decline in the Indian rupee for example has made more Indians want to hedge imported inflation which has been done through rising purchases and imports of gold. However, those purchases have not been enough to offset the sales by finance houses in the rest of Asia as they counter increased domestic interest rates and higher liquidity demands.
Secondly, gold is still being sold by major central banks as they need to diminish the commodity’s attraction for anyone considering alternatives to the existing monetary system. That disconnect between physical holdings of gold and the price swings of paper gold is therefore another indication of such intervention.
What appears on the face of it to be a broad-based macro sell-off appears on closer examination to have more subtle variations and colorations in terms of what may be driving the process: increased government risks, demand for liquidity and a good old-fashioned “bank runs” are all part of the adjustment process as the “QE Coyote” phase begins for global asset markets.