Fed ‘taper’ is dicey game of dominoes

August 30, 2013 4:51 pm

Fed ‘taper’ is dicey game of dominoes

By Ralph Atkins in London

Lining up dominoes is a hazardous game, as any child knows. A small slip can result in the whole lot falling prematurely and chaotically. Investors may wonder whether Ben Bernanke, the US Federal Reserve chairman, is attempting a similar feat. Talk about Fed “tapering” – the central bank’s plans to scale back asset purchases, or “quantitative easing” – has driven US Treasury yields sharply higher since May. In response, investors have pulled out of riskier assets in emerging markets, sending share and bond prices spiralling downwards in countries such as India.By Friday, developing economy tensions had lost some intensity, and worries about Syria have helped US Treasuries rally this week. But the calm has done little to ease uncertainty about whether this will blow into a bigger crisis. Will “tapering” effects be controlled? Or might they disrupt other markets that benefited from exceptionally loose monetary policies – perhaps elsewhere in emerging economies or for high yield bonds, US real estate or southern eurozone government debt?

“Investors have to adjust to the notion that there is going to be more volatility from now on,” warns Russ Koesterich, global chief investment strategist at BlackRock. “A number of assets saw valuations get very elevated . . . As rates normalise, some of these assets are not going to perform as well as they did.”

Since the global financial crisis first erupted in 2007, investment experts have observed a “risk-on, risk-off” cycle in which asset prices all move together in response to global shocks, whether the collapse of Lehman Brothers investment bank or eurozone break-up risks.

This week “risk-on, risk-off” went mainstream. At a central bankers’ summit in Jackson Hole, Wyoming, a paper presented by Hélène Rey, economics professor at London Business School, identified a common global financial cycle driven in part by Fed actions, with asset prices following investors’ risk appetites as measured by “fear gauges” such as Wall Street’s Vix index of expected stock market volatility.

If she is right, the recent turmoil in emerging markets could spread. “If the reversing of easy monetary conditions is serious then, yes, I believe it will go across asset classes,” Ms Rey told the Financial Times. “But if the Fed acts slowly, it will be much easier for portfolios to adjust without major losses – it does depend on the speed.”

Some strategists are more cataclysmic. Not invited to Jackson Hole was Albert Edwards, Société Générale’s famously bearish global strategist, who warned this week the crisis would not be confined to emerging market economies with yawning current account deficits. “I see this as the beginning of a process where the most wobbly domino falls and topples the whole, precarious, rotten, risk-loving edifice that our policy makers have built,” he wrote in a note.

Still, many others are confident the effects of Fed action can be contained. “I’d say 90 per cent of ‘tapering starting in September’ is priced in – now we just need to see it starting,” says Pierre-Yves Bareau, global head of emerging market debt at JPMorgan Asset Management.

“Liquidity has to find a place somewhere,” he adds. “The real economy could absorb it – if companies built factories for instance. But at the moment global growth is flat, so it is matter of arbitrage. People look to where is the best place – I would not be surprised if we saw a return to emerging markets.”

Emerging market economies were vulnerable to hikes in US Treasury yields because they had seen the biggest capital inflows since QE started. Cumulative investment portfolio inflows into emerging markets, excluding China, have exceeded $780bn since 2009, according to calculations by Citigroup.

In contrast, US high-yield corporate debt markets are supported by stronger economic growth. Spanish and Italian sovereign yields have held steady during the recent emerging market turmoil – as fickle foreign investors have already fled. Simon Derrick, head of currency strategy at BNY Mellon, adds: “If what is happening in emerging markets intensifies, then it will keep upward pressure on the euro and yen – which, bizarrely enough, are safe havens.”

Even as the Fed moves towards tapering, Japan is still taking aggressive action to stimulate its economy, which will continue to drive global liquidity flows, points out David Zahn, head of European fixed income at Franklin Templeton. “The Bank of Japan is probably making up for what the Fed has taken out,” he says.

Mr Koesterich of BlackRock argues the Fed will ensure Treasury yields do not rise too rapidly. “If yields keep going up too fast and threaten to unravel the economy, as we have seen a bit in housing markets, that’s when the Fed may want to act.”

Matt King, credit analyst at Citigroup, says his “best guess” is that a domino run will not start any time soon – or at least central banks would act to prevent one. But he admits: “That’s a bit like leaving the room and hoping that when you come back later you’ll still find all the dominoes standing. As those with younger brothers will know, you ought to be OK . . .”