A New Twist in Monetary Policy: Divergence Between Emerging and Developed Markets; Emerging markets are cutting interest rates in response to disinflation and slowing growth while investors speculate on an early exit, or taper, by the Fed

A New Twist in Monetary Policy: Divergence Between Emerging and Developed Markets

31 MAY 2013 – TOM BUERKLE

For the past five years, policymakers in emerging-markets countries have criticized their U.S. counterparts, arguing that the Federal Reserve Board’s zero interest rates and quantitative easing have flooded the world with cheap money, pushed up asset prices and fanned inflationary pressures in their economies. Japan’s recent entry into the QE club merely generated more such complaints.

Behind that chatter, however, a significant shift is taking place. Advanced economies and emerging markets remain out of sync, but with a twist: While investors are increasingly speculating that the Federal Reserve Board will begin exiting or tapering its easy-money policies sooner than expected this year in response to stronger growth, emerging markets have been cutting rates lately in the wake of a slowdown in growth and waning inflation pressures. Many analysts and investors believe this new trend has plenty of room to run.“You’re seeing growth generally fading across the board in emerging markets. Data is weak and disappointing,” says Rashique Rahman, head of emerging-markets macro strategy at Morgan Stanley in New  York. “The market has priced in a steady slice of easing for most of the year in most emerging markets.”

Late last month Israel and Hungary became the latest countries to cut rates. The Bank of Israel trimmed its key lending rate by a quarter point, the second such reduction in two weeks, leaving it at 1.25 percent. On the same day the National Bank of Hungary cut its policy rate by 25 basis points for the tenth straight month, reducing it to a record low of 4.5 percent.

Since new governor Haruhiko Kuroda initiated a dramatic QE program at the Bank of Japan in April, seven nations — Australia, Hungary, India, Israel, Poland, South Korea and Turkey — have cut interest rates. A total of 15 countries have done so since the start of the year, a surprise considering that most analysts had been predicting that rates would tend to go up in emerging markets.

What’s going on? Torsten Slok, chief international economist at Deutsche Bank in New  York, says the rate cuts reflect a broad slowdown in emerging markets at a time when investors are feeling more confident about the U.S. outlook and speculating about a shift in the Fed’s stance. He points to a surge in talk about tapering: A Google search for “taper” and “Fed” generated 3.43 million results.

“It has just exploded in the past few weeks,” Slok says. “It’s clear the trend for the U.S. economy is up” and U.S. financial markets should outperform, he adds.

Jan Dehn, chief economist at Ashmore Investment Management, a London-based fund manager specializing in emerging markets, believes talk of a sharp early Fed tightening is overdone. Household debt levels will continue to restrain growth in the near term, he contends, and Ben Bernanke’s Fed “is going to be very active in leaning against the market” to prevent a 1994-style bond rout.

Still, the U.S. recovery stands in contrast to growing sluggishness and disinflation in emerging economies, Dehn notes. China sets the pace, with growth having slowed to a rate of about 7.5 percent and producer prices falling at a 2.6 percent pace in April.

“This is what is going to happen in a lot of EM countries. They can’t rely on export-led growth,” Dehn says. “We are going to see rates coming down gradually for a number of years in emerging markets.”

Alberto Ades, New  York–based head of emerging-markets fixed-income strategy at Bank of America Merrill Lynch, sees Poland as one of the best candidates for rate cuts later this year. He predicts that the National Bank of Poland could cut its lending rate to as low as 1.5 percent from the current level of 3 percent. Chile and Mexico may also cut rates in coming months, says Ades, adding, “We think the environment for fixed income in the emerging markets is very supportive.”

Even countries with a tightening bias, like Brazil, may raise rates by less than many investors expect. Responding to a recent rise in inflation to 6.5 percent, the upper range of its target, the Central Bank of Brazil raised its key lending rate for the first time in nearly two years in April, boosting it by a quarter point, to 7.5 percent.

“Policymakers will continue to talk tough on inflation but tread lightly in terms of actual tightening, while waiting for other disinflationary factors to play out in the coming months,” Eamon Aghdasi, an emerging-markets strategist at Société Générale in New York, told clients in a research note.