Geopolitical risk: Fed up? US causes panic in emerging markets

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15 Oct 2013

The Fed has replaced Europe as the dominant force driving investor sentiment. After suggesting quantitative easing (QE) could be reduced as early as September, markets went into panic mode. Many emerging markets fell into mini-crises as currencies and equities fell sharply on concern the money supply would decrease and interest rates could rise earlier than expected. Yet come September, the Fed failed to deliver, throwing markets back into a spin.

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The Fed has replaced Europe as the dominant force driving investor sentiment. After suggesting quantitative easing (QE) could be reduced as early as September, markets went into panic mode. Many emerging markets fell into mini-crises as currencies and equities fell sharply on concern the money supply would decrease and interest rates could rise earlier than expected. Yet come September, the Fed failed to deliver, throwing markets back into a spin.

The Fed has replaced Europe as the dominant force driving investor sentiment. After suggesting quantitative easing (QE) could be reduced as early as September, markets went into panic mode. Many emerging markets fell into mini-crises as currencies and equities fell sharply on concern the money supply would decrease and interest rates could rise earlier than expected. Yet come September, the Fed failed to deliver, throwing markets back into a spin.

“The Fed’s change in tack has created uncertainty in the bond market as there is now a very uncertain path for both QE in the short to medium term and interest rates in the medium to long term,” according to Chris Iggo, chief investment officer, fixed income, at Axa Investment Managers.

“The Fed has clouded the outlook in terms of what economic data is the most important and created doubt about what its reaction function is,” he continues. “More uncertainty means higher risk premiums on rates. If the economic data comes out strong, this will create volatility in interest rate movements.”

Implied bond volatility has increased significantly since May. The Merrill Lynch Option Volatility Estimate (MOVE) index jumped up from 49 to 118 between 3 May and 5 July, reaching levels not seen since the end of 2011. On 6 September it was just above 105. According to Luca Paolini, chief strategist at Pictet Asset Management: “Market turbulence should be expected during a Fed tightening cycle. We saw it in 2004. We have a situation where investors are scared and every small move of the Fed has a bigger impact on markets than usual.”

Emerging markets (EMs) appear worst affected by the prospect of tapering with currencies from the Indian rupee to the South African rand and the Brazilian real plunging against the dollar. Dollar appreciation will tighten domestic monetary conditions for many EMs as their cost of borrowing will increase and inflationary risk arises as many commodities are priced in dollars. Such loose US monetary policy, coupled with the flood of money thrown into EMs, also allowed investors to overlook the lack of structural reform in many countries. That has come to the fore since May. India, for example, faces a trinity of economic problems: record deficit, fragile currency and the lowest growth in 10 years.

Emerging markets have also been the main beneficiaries of the delay to tapering, but without that much-needed reform, the reprieve will only be temporary and another, potentially sharp, downward correction should be expected.

“EM currencies have suffered considerably since May, when the Fed first started looking towards a September taper. The removal of cheap and easy money saw many funds close off their profitable EM trades in preparation for taper,” according to Peter O’Flanagan, head of FX dealing at boutique foreign exchange company Clear Currency.

“Now this has been put back these trades will once again be attractive. The revival in EM trades is only temporary (two to three months) though.”

Markets are now expecting tapering will not begin before December, although there is still considerable uncertainty, especially considering the new chairman of the Fed come Bernanke’s departure at the end of January is still undecided. Bernanke has been clear economic data will need to show signs of steady improvement for tapering to begin.

However, Janet Yellen is now a firm favourite for the chairmanship, and feels policy should remain accommodative for a considerable time, until economic and jobs growth come back in line with target. This could be partly behind the Fed’s decision to delay.

“This may see the US remain accommodative for far longer than the market even expects now, but the truth will be in the data over the next three months,” O’Flanagan says. However, despite its efforts to become more transparent, the Fed has confused markets. The Fed sent what investors believed was a very strong signal earlier this year that the asset purchasing programme would be gradually reduced and the FOMC meeting in September was a likely starting point. Whether this has been a miscommunication by the Fed or misinterpretation by investors is open to debate, but investors now feel more in the dark.

“It has done a lot of damage to the Fed’s credibility,” Axa IM’s Iggo says. “The point of forward guidance was to set out the future path of monetary policy actions in a clear and transparent way, with that future path being somewhat conditional on clearly articulated economic thresholds.”

The Fed has yet to clearly define those thresholds and uncertainty about Fed policy and communication makes it much harder for investors to price in rate hikes accurately and raises questions about the strength of the US recovery.

As a result, markets will likely remain in limbo until a new chair is confirmed and greater clarity is provided on the gradual reduction of QE and the outlook for interest rates.

The result will be a continuation of Fed-led sentiment driving markets over the medium term. Markets will be more sensitive to economic data coming out of the US with volatility likely to occur, especially on the back of positive data.

Investors should therefore prepare themselves for bond market volatility as the yield normalisation process continues and they should consider taking profits in emerging markets or putting hedges in place to protect from the event of another downward correction.

As Iggo concludes: “Investors may want to try to insulate themselves from this volatility in rates by focussing exposure on short duration and gaining credit risk premium from high yield and some parts of the investment grade universe. “Being tactical is important as asset values are likely to get inflated during this new regime and protection against an eventual sell off in risk assets should be considered going forward.”

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