Opinion

James Saft

Sidelined Fed a boon for emerging markets

May 21, 2014

May 21 (Reuters) – U.S. interest rates are staying low for
quite some time, a backdrop which should, all else equal, favor
emerging markets.

Remember the taper tantrum last year, when fragile emerging
market countries took huge hits as investors moved to tighten
liquidity ahead of an anticipated Fed cutback on bond buying?
Well that’s all in the past and, particularly in the past week,
the noises from within and around the Federal Reserve are
painting a newly dovish picture.

That’s significant for all markets but it is an
unadulterated bonus for emerging markets, particularly those
which need to attract capital and are therefore highly sensitive
to its global cost and availability.

The taper has become reality, and yet, amid signs of
economic weakness from Europe and the U.S., market interest
rates have dropped and the bid for riskier assets has generally
been relatively good.

This is not to ignore the host of issues in emerging markets
from Russian aggression in Ukraine to a rather precipitous
slowdown in China. But remember, any problem which arises from
within emerging markets will only be made much worse by a
hawkish Fed. Indeed a Fed which is tightening has historically
been an important contributory cause of problems from within
emerging markets. Supportive policy from the Fed is almost a
necessary precondition for outperformance in emerging markets.

WHAT’S UP WITH THE FED?

So first off, why should we believe that the Fed is now more
dovish than a week or two ago?

For one thing, Ben Bernanke, now doing the rubber chicken
circuit at something like $250,000 a pop, is telling us so.
While reports are all at best second hand at these private,
no-journalists-allowed dinners, the vibe coming out through the
media is that rates are not headed up soon.

Not only did Bernanke indicate the Fed might tolerate
inflation above its 2 percent target, one guest came away with
the impression Bernanke believes the fed funds rate won’t return
to its historical average of about 4 percent in his lifetime.
(here)

But if you don’t like back-room tea-leaf reading, and who
could blame you, take it straight from the Fed in speeches and
interviews. Bill Dudley, president of the New York Fed, argued
publicly this week against the idea that the 2 percent target
was a ceiling, maintaining that, once reached, we might be
expected to spend as much time above that level as below it.

Dudley was noncommittal about the timing of a first rate
rise and stressed that increases, once they begin, would be
quite slow.
(here)

Or consider an interview Boston Fed President Eric Rosengren
gave to the Wall Street Journal in which he proposed that the
Fed may want to continue reinvesting maturing securities held on
its balance sheet even after the taper is completed, maintaining
that a large balance sheet may be a needed tool to allow the Fed
to manage financial stability.
(here)

Low rates for a long time and a Fed with both a huge balance
sheet and a tolerance for small inflation overshoots must sound
pretty good to Indian central bank chief Raghuram Rajan or South
Africa’s Minister of Finance Pravin Gordhan.

VOLATILITY AND FLOWS

Indeed we’ve seen some signs that emerging market assets are
moving to price this in, and there is some hope that this
continues. The MSCI emerging markets index has
outperformed both the S&P 500 and Euro Stoxx 50
year to date and over the past week and month.

Particularly interesting is a decline in volatility in
emerging markets. The CBOE’s Emerging Markets ETF, a
fear gauge for emerging markets, has shown a strong decline in
volatility recently, slumping 35 percent since mid-March, far
outpacing the fall in the U.S. VIX volatility index.

Analysts at Barclays Capital note that the relative
volatility in emerging markets compared to developed ones has
dropped sharply since last year but that the extra real yield
you get by holding an emerging market sovereign bond has
actually increased, something they believe may indicate scope
for a reduction in emerging market risk premiums.

“The key question is: is this elevated level of risk premia
reasonable? Our analysis looks at potential equity risk premium
drivers and suggests the answer is no,” Barcap global equity
strategist Joao Toniato writes in a note to clients.

Much depends on what use emerging market officials make of
an extended period of easy liquidity. It would be easy, as in
the past, to use it as an excuse to delay reforms and make
politically popular but perhaps low-yielding investments.

Still better, both for emerging markets and for investors in
emerging markets, to hold the choice in your own hands rather
than have your tightening done for you in Washington.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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