US Fed Tapering Is Postponed-VRK100-19Sep2013

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A word of appreciation for this post from Bibek Debroy, a renowned economist.

@vrk100 Good piece.
— Bibek Debroy (@bibekdebroy) September 19, 2013

Summary:

The US Federal Reserve on 18 September 2013, at its Federal Open Market Committee (FOMC), decided to postpone its much talked-about tapering for the time being. This means the US Fed is maintaining its status quo of buying bonds worth $85 billion per month. It’s not clear when the Fed will start its tapering. With this flip-flop, the US Fed has made it difficult to predict when it will gradually reduce its bond buying program. Due to the moderate economic growth, low labor participation and recent rise in mortgage rates, the Fed has decided to postpone the tapering decision. With this decision, the US dollar is down, gold price is up, and stock markets too have cheered the Fed decision.

What is Fed Tapering?

Before we move further, let us see what is meant by Fed tapering. Tapering means to reduce gradually. In May this year, the Fed had hinted that it would decrease its monthly bond buying program (See more on QE3 at this end of this post) at a measured pace. At that time it was perceived that the tapering would start in September this year and would end by the middle of 2014. The markets had taken this news of US Fed tapering very negatively. Even though attempts were made to assuage the markets subsequently, the market perception did not change. The US Fed, the IMF and the ECB tried to calm the nerves of financial markets, by saying that they’d continue with their easy money policies as long as their economies remain weak.

This Fed’ hint of tapering its bond buying created a flutter in the financial markets. The yield of US 10-year Treasury increased from 1.6% in May 2013 to 3% in early September 2013. There was huge sell-off in securities, both shares and bonds, in the EMs resulting in huge outflow of money from EMs back to the developed markets. Against the US dollar, currencies in the EMs have depreciated very sharply—ranging from eight to 12 per cent.

Why the Fed postponed the tapering?

As clarified by the Fed chairman Ben Bernanke there are three main reasons for its decision to continue with its bond buying and postpone the tapering:

1. Labor force participation rate has declined—partly reflecting potential workers getting discouraged. Though the unemployment has fallen to 7.3 per cent, the fall is substantially due to people leaving the labor force.

2. There is a tussle in the US congress over passing of a bill to keep the government funded (if there is no agreement between the Republicans and the Democrats, it may lead to a government shutdown in the US). This tussle may dampen the economic growth.

3. Mortgage rates in the US have gone up recently (after the hint of tapering)

The status quo remains for now:

As far as the financial markets are concerned, the status quo remains for the time being. There is no change in the QE. The Fed will continue with its buying program at the current levels. In the words of FOMC:

“However, the Committee (FOMC) decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.”

This implies that the US economy is still facing challenges and the monetary stimulus is still necessary for achieving maximum employment and price stability. To stimulate the economy, the Fed will continue to print money.

  

What is the state of the US economy?

The US economy is improving, but at a moderate pace. The unemployment rate remains high even though there are positives in the labor market. Some improvements in the economy are: increase in household spending, growth in fixed investment and strengthening housing sector. Inflation is as per expectations. On the negative side, mortgage rates have gone up recently and the economic growth is constrained by fiscal policy.

In the last one year, unemployment rate has fallen from 8.1 percent to the current 7.3 percent and about 2.3 million private-sector jobs have been created. One of the reasons for dip in the unemployment rate is the decline in labor force participation rate owing to people exiting the workforce.

When will the Fed start its tapering?

Between May 22^nd this year when the Fed hinted at tapering and now, the financial markets—bond, stock, currency and commodity—have undergone immense volatility. EMs were subject to large outflow of funds. The Fed decision not to taper has taken the financial markets by surprise. In the last 12 to 14 hours, the global stock markets have gone up thinking that the Fed stimulus will increase fund flows into financial markets and EMs.

The tapering decision is now postponed. What lies ahead? When will the Fed start reversing its easy money policy? What is the timeline for the Fed to start raising the federal funds rate? The answers remain elusive. The Fed’s about-turn is bound to confuse the markets, making it difficult to forecast the future Fed decisions. The Fed will keep its focus on US economic growth and unemployment rate.

The Fed’s projections indicate the US economy may grow between 2.0 to 2.3 percent in 2013, rising to 2.9 to 3.1 percent in 2014 and 2.5 to 3.3 percent in 2016. The unemployment rate may decline to 6.4 to 6.8 percent in 2014 and to 5.4 to 5.9 percent by 2016. Inflation may remain between 1.1 and 1.2 percent in 2013; 1.3 to 1.8 percent in 2014; and 1.7 to 2.0 percent in 2016.

Overall, the Fed is expecting a moderate recovery in the US economy and its future monetary policy will be based on fostering maximum employment and price stability. My overall feeling is that the US would not be able to start tapering for another 12 to 18 months.

When will the Fed start increasing the fed rate?

Another persistent and relevant question that bothers the markets is when the Fed will start increasing the fed rate. The fed rate has been kept at a record low of 0 to 0.25 percent since December 2008.  

Related: The Fed rate has been cut to record low

What is the difference between US Fed rate and US Discount rate

The Fed has linked its bond buying program to the outlook for the labor market. So, any decision on a tight money policy, that is raising the federal funds rate, will depend on the labor market conditions. The Fed is committed to continuing the fed rate at record lows as long as the unemployment rate remains above 6.5 percent, and so long as inflationary expectations are well under Fed’s comfortable levels.

The Fed is categorical that a decline in the unemployment rate to 6.5 percent would not lead automatically to an increase in the fed rate. Once the unemployment rate goes below 6.5 percent, it will take a decision on the revision of fed rate keeping in mind the overall economic outlook and labor market conditions, especially job gains. In the words of the US Fed:

“…the first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent.”

Market Reaction:

The US Fed's decision has been welcomed by the world’s financial markets. The market perception is that the money taps will continue to be kept open by the central banks. The US stock indices have gone up by around one percent clocking record highs. The Asian stock markets have gone up by two to four percent.

The US dollar is down, while gold and oil prices are up. 

Conclusion:

The Fed has flagged certain fiscal policy problems for the US economy. It is concerned that these problems could be detrimental to the economic growth. There is an ongoing controversy in the US congress over government funding deadline of 30^th September. These may entail certain risks for the markets in the coming weeks or months.

The fact that the Fed will continue to print money seems to have cheered the markets. However, there is one dissenting voice in the FOMC. Ester George, one of the FOMC members has cautioned that the massive bond buying program may result it future economic and financial imbalances and higher inflation.

The real problem is that the markets may react violently again when the Fed decides to start tapering. In fact, the admission that the US economy’s growth has moderated should be a negative in the medium term for the markets. But, the markets are currently happy with the Fed decision.

I think market will have to realize the larger picture at some point in future. The reality is that one day these central banks have to stop their massive liquidity injection programs, resulting in large money outflows from emerging to developed markets. 

We need to keep our focus on the ensuing economic indicators.

Related: Emerging markets are down but not out 

References:

FOMC press release dated 18Sep2013

Bernanke’s press conference

Photo courtesy: US Federal Reserve.

Abbreviations:

BoJ – Bank of Japan

DMs – Developed Markets

ECB – European Central Bank

EMs – Emerging Markets

IMF – International Monetary Fund

Taper Tantrum

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Additional Reading

I. What is QE3?

After the 2007/2008 global financial crisis, the Fed has been trying to stimulate the US economy with its easy money policy. The Fed has been following an unconventional monetary policy of buying bonds called quantitative easing (QE) as it cannot further lower the current federal funds (fed rate) target of 0 to 0.25 per cent. In the last six years or so, the Fed has increased its monetary base by almost four times as part of the QE, whereby it buys bonds from commercial banks and other financial institutions.

This is aimed at decreasing interest rates and boosting the US economic and job growth. As part of its quantitative easing (QE) program started in September 2012, the Fed has been buying bonds worth $85 billion per month—consisting of US Treasury securities worth $45 billion and mortgage-backed securities (MBS) worth $40 billion. This is the third version of the program, called QE3.

In the first round of quantitative easing (QE1) between November 2008 and March 2010, the Fed bought MBS worth $1,250 billion and agency MBS worth $175 billion, in addition to purchase of US Treasuries. In the second round (QE2) between November 2010 and June 2011, the Fed bought US Treasuries worth $600 billion. Officially, the QE program is known as large scale asset purchases or LSAPs. In layman’s lingo, the QE has increased money supply by leaps and bounds in the banking system, resulting in massive printing of US dollars. This tremendous liquidity has flown out of the US and reached several financial centers around the globe, inflating prices of commodities, EM securities and other asset classes.

II. What monetary policy tools are used by the US Federal Reserve?

In normal times the Fed eases monetary policy by lowering its target for the short-term policy interest rate, known as the federal funds rate, or fed rate. For more than 50 years, the Fed has used the fed rate as a conventional monetary policy instrument. In December 2008, the Fed decreased the fed rate to a record low of 0 to 0.25 percent. After that, the Fed was forced to use other unconventional tools at its disposal, due to the fact that current federal funds rate of 0 to 0.25 per cent could not be lowered further. So, how could the Fed signal interest rates in the economy?

Since the latter part of 2008, the Fed has been using the following two tools:

1. Large scale asset purchases, commonly known as quantitative easing, whereby the Fed has been buying US Treasuries, MBS and others; and

2. Forward guidance about short-term interest rates; that is, communicating its plans for setting the fed rate target over the medium term.

III. What is the mandate of the US Fed?

As per the Federal Reserve Act, the statutory objectives for monetary policy are: maximum employment, stable prices and moderate long-term interest rates. The Fed tries to target inflation rate at two percent. Further, the objectives of the monetary policy should be explained to the public as clearly as possible fostering better communications; enhancing transparency and accountability; and reducing economic and financial uncertainty.

IV. Why is US inflation not rising despite increased money supply?

Even though the Fed has increased its balance sheet by almost four times in the last six years, there has been no alarming increase in the US inflation. This is due to the fact the US commercial banks’ lending growth is sluggish.

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Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial advisor before taking any investment decisions. He blogs at:

http://ramakrishnavadlamudi.blogspot.in/

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Emerging Markets: Down but not Out-VRK100-10Aug2013

Rama Krishna Vadlamudi, HYDERABAD       10 August 2013
www.ramakrishnavadlamudi.blogspot.com

Since the beginning of this calendar year 2013, emerging markets are down. Various reasons can be attributed to the steep decline. Predominantly, the perception of the US Federal Reserve tapering its bond buying program (QE 3) has rattled the world markets in the last two months. This has resulted in large outflow of money from emerging markets to developed markets. Of course, emerging economies have their own domestic problems, ranging from street protests, currency depreciation, large deficits, and steep fall in commodity prices. Global investors have started realigning their portfolios, moving from emerging markets to developed ones. The trend may continue for another few quarters, before investors flock back to emerging markets—which are currently down, but not out.

Comparing Equity Returns of Developed & Emerging Markets (2003-2012):

Notes: S&P 500 index represents US equities; MSCI EAFE - MSCI Europe, Australasia and the Far East index (excludes US and Canada); and MSCI EM - MSCI Emerging Markets index.

The MSCI EM index has outperformed both the S&P 500 and MSCI EAFE indices in eight out of ten years between 2003 and 2012. The equity returns are depicted in the above graph. Only in 2008 and 2011, the emerging markets equity returns underperformed both the US equities; and world equities (ex-US and Canada).

During the current calendar year 2013, the emerging markets have underperformed the US equities, as well as other developed markets. What is troublesome for market participants now is that the underperformance is very large. While the MSCI EM index has fallen by about 10 percent, the S&P 500 has surged by 18 percent, indicating an overall underperformance of about 28 percent for emerging markets in 2013 so far. This underperformance is due to fall, in the range of 10 to 20 percent, of equities in Brazil, Russia, China and India.

In Japan, the Prime Minister Shinzo Abe has vowed to double the country’s monetary base in two years—with Bank of Japan injecting massive doses of liquidity into the markets, in order to boost the crippled economy and tackle the entrenched deflation. Following this, the Japanese Yen has depreciated against the US dollar by 11 percent in 2013, while the Nikkei stock market index has shot up by 31 percent. Stock markets in the UK, Germany and France too have gone up this year.

What Caused this Underperformance of EMs in 2013?

In May this year, the US Federal Reserve had hinted at tapering of its bond buying program (QE3). It was perceived that the tapering would start in September this year and would end by the middle of 2014. The markets have taken this news of US Fed tapering very negatively. Even though attempts have been made to assuage the markets subsequently, the market perception has not changed. The US Fed, the IMF and the ECB have tried to calm the nerves of financial markets, by saying that they’ll try the easy money policies as long as their economies remain weak. The reality is that one day these central banks have to stop their massive liquidity injection programs, resulting in large money outflows from emerging to developed markets. 

With the hint of US Fed tapering, global investors have started selling securities, both equity and bond, in emerging markets and taking their funds back to the developed markets. The yield of 10-year US Treasury note has increased from 1.6% in May to the current 2.58%, attracting funds back to the US markets, in some sort of trend reversal.

(As part of its Quantitative Easing 3 or QE3 program, the US Fed is committed to buying bonds worth $85 billion per month. When central banks buy bonds, they inject liquidity into the banking system. The massive monetary stimulus from developed economies since the 2007/2008 Global Financial Crisis, particularly the US Fed, has resulted in enormous liquidity, said to be about $12 trillion, in the world fuelling price inflation in the emerging market equities/bonds and world commodities. This excess money has been circulating around the world, chasing returns and yields.)

Weakness in BRICS markets:

With the BRICs markets grossly underperforming the developed market indices, investors have started focusing on risks in emerging markets. In general, investors demand higher equity risk premium to invest in emerging market securities, due to higher risks in them as compared to developed markets. Even debt market returns in emerging markets are negative this year. Brazil and Turkey have faced massive street protests recently—impacting the investor sentiment negatively. (Interestingly, Turkey’s sovereign rating was upgraded to investment grade by Moody’s in May 2013).

India is facing its own problems. The Damocles sword of a rating downgrade by Standard & Poor’s is hanging on its head for quite some time. It is running a large current account deficit, in addition to high fiscal deficit and stubborn food inflation. In July 2013, Brazil increased its interest rates from 8% to 8.5% in response to growing inflation rate, while Turkish central bank intervened heavily and sold US dollars to prop up Turkish lira.

Chinese economy has slowed down in the past few years. The new Chinese government is worried about local government debt and trying to put restrictions on budget deficits and bank credits. Global commodity prices have corrected. Year-to-date, gold has corrected by 20 percent and silver by 34 percent approximately. Even copper, zinc and aluminum have corrected between 10 to 13 percent. Commodity-producing countries such as, Brazil and Russia, have suffered following the commodity price decline. However, crude oil prices have remained firm.

The commentary from experts indicates that the fancy for emerging market stocks and bonds has faded away for the time being, as the focus has shifted to developed markets and investors seem to have shifted their loyalty away from emerging markets.

Brazilian real, South African rand, Indian rupee, and Turkish lira have fallen anywhere between 8 to 12 percent since May this year, after the talk of US Fed tapering hit the markets. These currency depreciations have prompted selling in emerging markets.

Convergence between Emerging and Developed Markets:

Over the years, emerging markets have evolved with gradual opening up of their economies, achieving superior economic growths and creating a sense of political maturity. One interesting development in recent years is that it is difficult to distinguish between companies in the developed markets and emerging markets. For example, a large number of US and European multi-national companies (MNCs) derive their revenues from outside their countries, including those in the emerging market group. The US-based companies, IBM, Accenture, Coca Cola, and Pfizer generate more than 50 percent of their total revenues from non-US countries. So are Swiss-based Nestle and UK-based Unilever.

Even companies in the emerging countries have acquired a global status by acquiring companies in the developed world. India’s Tata Motors has acquired JLR, the Birlas have acquired Novelis, and Apollo Tyres is taking over US-based Cooper Tire and Rubber.

There was a time when different economies used to follow different monetary and fiscal policies. After the Global Financial Crisis, most of the developed economies have been following similar monetary policies—that is, buying bonds and injecting money into the financial markets. The US Fed, the ECB and the BoJ have followed these massive bond buying programs.

Convergence in the world markets has gone up. Correlations across equity markets have increased in recent years, especially in the last decade following increased globalization, massive surge in cheap money and interdependence of global trade.

Still Differences Exist:

While differences have narrowed down, there remain still a lot of differences between developed and emerging economies. Emerging markets still carry higher risks—ranging from volatile political/social environment, heavy dependence on commodities, weaker capital market regulation, higher market volatility, unsustainable current account deficits and currency risks. Global wealth is concentrated in developed countries.

Emerging Markets: Poised for Comeback:

At one end, global investors chase growth and/or yield. They’re quick to withdraw or invest their money at very short notice. But at the other end, large institutional investors, like pension funds, insurance companies and foundations, look for stable and long term returns. They lend stability to financial markets—be it equity or bond. They play an anchoring role in markets.

Emerging markets will continue to attract investor interest. Unilever increased its stake in Hindustan Unilever, its Indian subsidiary, from 52% to 68% by pumping in $3.2 billion. Diageo of the UK bought India’s United Spirits and UK-based BP invested in Reliance Industries’ gas blocks.

While emerging markets have not been doing well as compared to the developed ones at present, there exists a large potential for emerging markets to grow much faster than developed markets. Of course, there will be some rotation in the list of emerging markets. The focus of global investors will shift to newly emerging markets, where the prospects would be much better. The future of developed and emerging markets is interlinked. Higher fertility rates, advances in technology, education & healthcare, favorable demographic changes, and domestic consumption are still the star attractions for emerging markets. The negativity surrounding developing countries is justified, but no one can deny their potential for future and faster growth.

They’re down, but it’s not time to write them off.

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Notes:

BoJ – Bank of Japan

BRICs – A grouping of Brazil, Russia, India and China (sometimes South Africa is also included)

DMs – Developed Markets

ECB – European Central Bank

EMs – Emerging Markets

IMF – International Monetary Fund

Disclaimer: The author is an investment analyst and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial adviser before making any investment decisions. The author’s articles on financial markets and Indian economy can be reached at:

http://ramakrishnavadlamudi.blogspot.in/