The U.S. Federal Reserve’s now open debate about the
beginning of the end of its massive money-printing programmes
caused gyrations on stock and bond markets everywhere this week.

Even the prospect of the Fed reducing the amount of dollars
it’s been flooding into the domestic and global economies via
its bond-buying policy has seen several strategists crank up
long-term dollar forecasts significantly.

The scenario raises concerns among many economists of what’s
become known as “sudden stops” in western investment flows to
emerging markets – the most spectacular being the 1997/98
currency crises across Asia, Russia and Latin America but yet
again at the height of the credit crisis in late 2008/2009.

And that 1990′s crash coincided with a sustained dollar
rally over many years and an investor shift back to the United
States.

The bullish case for the dollar has been building for months
- U.S. growth rates outstripping western peers; an entrenched
housing recovery; cheaper domestic energy from shale and its
likely shrinkage of U.S. trade deficits; and even the relocation
of some U.S. industry back home have been oft-cited factors.

But these tailwinds have struggled to lift the dollar to
date as long as the Fed’s dollar printing weighed down its
exchange rates. If that headwind were now even to weaken from
storm force to a mere gale, then lift-off may be in sight.

“We cannot think of a better environment for further dollar
over-peformance, irrespective of gyrations in U.S. equities,”
said Citi emerging markets strategist Luis Costa, scaling back
overweight recommendations on some emerging debt in the process.

HSBC strategist David Bloom, ratcheting up the bank’s
end-year dollar forecasts, reckons low global inflation is
allowing central banks everywhere to step up the “currency war”
and weaken local units via lower interest rates or outright
currency sales in an anxious dash to offset flagging growth.

Armed with a pick up in its domestic economy, the dollar
could now absorb that worldwide push to devalue.

“We believe we have entered a dollar bull environment,” he
said, adding that any Fed shift in the opposite direction would
simply reinforce significant dollar appreciation of 10 percent
or more before U.S. authorities would feel any need to object.

BOON OR BOMB?

So if a higher dollar trajectory is now in view, why all the
nerves about emerging markets? Taking comfort from exporters’
relief at weakening currencies, for example, Turkish and South
African equities barrelled to record highs this week.

The broader anxiety is that a decade of staggering
investment flows to emerging economies – some $8 trillion since
2004 on some estimates – has ridden on the back of both a
commodities “super cycle” over the past decade and a protracted
strengthening of emerging currencies against the dollar.

The Fed’s inflation-adjusted and trade-weighted dollar index
against a broad sweep of mostly developing countries, for
example, has fallen more than 25 percent over the past 10 years.

But if both the long-term commodity price surge and a
weakening dollar are at a long-term turning point, then the
metrics of investment in emerging markets may shift also – with
nearly half of the $80 trillion of world’s private pension,
insurance and mutual funds still based in the United States.

What’s more, the latest investor wave into emerging markets
has been into bond markets – much of it denominated in local
currencies and where index-wide yields are near record lows.

JPMorgan estimates total new sovereign and corporate bond
sales from emerging markets soared to a record of $411 billion
last year alone, some 30 percent higher than 2011.

The combination of local currency losses against the dollar
and higher U.S. bond yields over the coming years could
seriously disturb those investment calculations, not least in a
period where economic growth rates in China and other developing
giants are slowing relative to the United States.

In a note to clients on Thursday entitled “Emerging markets
on tenterhooks”, Barclays said: “The interplay of supportive
emerging market (debt) fundamentals and uncertainty about U.S.
Treasury yields leaves EM fixed income on an uncertain footing.”

Developing economies and markets are more robust now, argue
optimists. There are fewer fixed currency pegs and more flexible
exchange rate adjustments which reduce the chance of sudden
shocks. Foreign cash reserves are far higher after 10 years of
inflows and government debt positions and credit quality have
improved and are, in some cases, even superior to the West.

Societe Generale says many investors have added emerging
bonds to portfolios of late because they have become both less
volatile and less correlated with other assets – hence they are
holding them to stabilise portfolios.

Goldman Sachs insist that painting emerging markets with one
brush is misleading and the dispersion of returns within the
emerging market universe is rising. Picking the right ones -
Turkey or Indonesia equities so far this year – is the best
strategy, they say.

But with many investors still invested in broad emerging
markets buckets or indices, the combined dollar and U.S. yield
reversal along with slower emerging world growth could still be
dangerous for both the stars as well as the laggards.

And for risk-wary fund managers there are liquidity concern
about – the ease of selling at a fair price during a crash.

The central banks are clearly treading a fine line between getting traction in the real economy and not blowing new financial bubbles. The decider may be inflation and on that score central banks have a lot of leeway right now – global inflation is still evaporating and, as measured by JPM, fell in April to just 2.0% – its lowest in 3-1/2 years.  That said, CPI was also very well behaved in the run-up to 2007 credit crisis – it was asset prices and not consumer inflation that caused the problem. So – expect to hear plenty more cat-and-mouse on this from the central banks over the coming weeks/months.

For investors, periodic pullbacks from here are justified and likely sensible. But it’s still hard to argue against a wholesale change of behaviour – which is merely to assume central banks will prevent further growth shocks but will take some time to transform persistently sluggish growth into anything like a sustained inflation-fueling expansion . As a result, funds will likely steer clear of “safe” havens of cash, gold, Swiss franc and yen despite this bounce and continue their migration to income everywhere, with a bias to relative growth stories within that and an exchange rate tilt according to the likely sequencing of QE exit– all of which points to the U.S. dollar if not its stock markets. And for many that may just mean repariation or staying at home –the US is still the homebase for two thirds of the world’s institutional funds, or some $55 trillion of savings.

And the dollar move is just starting to play out big in emerging markets, where emerging market currencies are on the back foot everywhere from Turkey to South Africa, South Korea and others. The reaction so far as been to lift local stock markets on potential exporter relief but a big question moving ahead is to what extent persistent exchange rate weakness will start to deter or even reverse foreign investment flows.

Next week is a busy if mixed bag – a heavy G7 data slate, with Japan a focus; rate decisions in Brazil, Thailand, Hungary and Canada, US Treasury and JGB debt auctions, EU flash inflation and jobless reports, and China’s Premier visiting Germany.

GLOBAL DATA/EVENTS TO WATCH

China Premier Li Keqiang meets German Chancellor Merkel in Berlin Sat

Africa Union summit in Addis Ababa Sat

Equatorial Guinea parliamentary elections Sun

BoJ’s Kuroda speaks in Tokyo Sun

Israel rate decision Mon

Japan 20-yr JGB auction Tues

French May consumer confidence Tues

Hungary rate decision Tues

French/German labour ministers meet in Paris Tues

US May consumer confidence/March house prices Tues

US 2-yr Treasury auction Tues

BoJ’s Kuroda speaks in Tokyo Weds

Japan April retail sales Weds

German May jobless/CPI Weds

Italy May biz confidence Weds

EZ April credit/M3 Weds

Brazil/Thai rate decisions Weds

Canada rate decision Weds

US 5-yr note auction Weds

IMF annual report on Japan Thurs

Japan 2-yr JGB auction Thurs

Swiss Q1 GDP Thurs

Italy govt bond auction Thurs

EZ May biz/consumer sentiment Thurs

EU summit in Brussels Thurs

US 7-yr Treasury auction Thurs

US Q1 GDP revision Thurs

Japan April jobless/production, May Yokyo CPI Fri

EZ flash May inflation/April jobless Fri

Italy April jobless, French April consumer spending Fri

UK April consumer credit/mortgage Fri

US May Chicago PMI, April personal spending/income/PCE Fri

Canada Q1 GDP Fri

China May manufacturing PMI Sat

Financial markets supercharged this year by the
extraordinary monetary stimuli of the top four central banks are
once again asking how long this can last.

Friday’s stall of this year’s global stocks market rally was
blamed by many on fresh policymaker chatter about when the U.S.
Federal Reserve will or should start to wind down its
bond-buying and money printing programmes, or “quantitative
easing”.

Ironically, the latest concern about the ‘beginning of the
end’ of QE is flaring after a week of data from both sides of
the Atlantic showing persistent weakness in the western
economies and an absence of any discernible inflation pressures.

So while few strategists reckon the end of QE is nigh, the
very debate itself may now force investors to rethink the
long-term horizon even if a reversal of investment flows is
unlikely.

“The U.S. and world economy is probably not strong enough to
end the QE effort any time soon,” said Philippe Gijsels, head of
research at BNP Paribas Fortis Global Markets. But “the market
itself has had a very steep run and so a pause or consolidation
becomes more likely and would be in fact desirable.”

Yet if the big four central bankers are listening to the
counsel of their monitors at the International Monetary Fund and
Bank for International Settlements, then the tone of the debate
has indeed changed this week.

While applauding central banks’ success in stabilising the
financial system over the past five years, the two global
monetary bodies on Thursday detailed the risks both of
persisting with extraordinary QE for too long and also the
potentially disruptive effects of turning off the taps.

And highlighting the lack of traction in boosting growth and
jobs, the common theme from the IMF and BIS was that monetary
policy alone may have reached the limits of what it can do and
other reforms and approaches now needed to be considered.

“If the medicine does not work as expected, it’s not
necessarily because the dosage was too low,” said BIS chief
Jamie Caruana. “Refocusing the policy mix to rely more on repair
and reform and not to overburden monetary policy is crucial
because the balance of risks of prolonged very low interest
rates and unconventional policies is shifting.”

Echoing that, IMF assistant director for monetary and
capital markets Karl Habermeier wrote: “Monetary policy cannot
do everything.”

BIG 4 AND DRAGHI’S REPRISE

In the coming week, leaders of all four top central banks -
the Fed, Bank of Japan, European Central Bank and Bank of
England – deliver keynote speeches amid all the unease at a
disconnect between seemingly euphoric markets, struggling
economies and evaporating inflation.

Fed chairman Ben Bernanke testifies to Congress on
Wednesday, Bank of Japan governor Haruhiko Kuroda speaks after
the bank’s latest policy meeting earlier that day and outgoing
BoE head Mervyn King speaks in Helsinki on Friday.

Pointedly, ECB chief Mario Draghi returns to the financial
community in London on Thursday for the first time since July
when he drew a line under the euro crisis by pledging to do
“whatever it takes” to protect the shared currency.

Given that phrase also neatly framed the determination of
all G4 central banks to plough ahead with extraordinary monetary
easing – the Fed’s stepped up bond-buying plan to cut U.S.
jobless or the ‘shock-and-awe’ tactics of the new Japanese
government and Bank of Japan – they may all now be taking stock.

What’s clear is that investors, if not the real economy,
have run with their plan so far.

Total returns on Spanish or Greek equities and euro zone
bank stocks are up between 40 and 50 percent since last July.
Italian, French and German equities and Spanish and Irish
10-year government bonds have all returned 30 percent or more.
While these have outperformed the 25 percent gains in Wall St’s
S&P 500 since then, the latter has powered to all-time highs.

All pale in comparison with the eye-popping 75 percent rise
in Japan’s Nikkei 225 in just six months and bond borrowing
rates from the highest to lowest rated sovereigns and corporates
across the globe have fallen or remained close to historic lows.

So if central banks now want to flag an inflection point in
policy thinking, should investors take their cue from that too?

For many, the seismic shift in investor flows is still not
as speculative as it may appear.

Flows to both corporate bonds and largely defensive
dividend-heavy equities this year are still fuelled largely by
an exit from near zero-yielding money markets funds in search of
long-term income rather than quick price rises or capital
growth.

It’s the success of the central banks in convincing
investors they will not tolerate another systemic or growth
shock that is still driving that exit from cash bunkers.

Far from being excessively optimistic about the world
economy per se, many strategists reckon that investors will only
change that behaviour when the central banks actually succeed in
generating faster growth and credit expansion in the real
economy – changing the inflation and interest rate horizon.

Credit Suisse economists said this was the peculiarity of
the current QE-related “yield grab” – faster growth rather than
low growth or stagnant economies was the bigger risk.

“This vulnerability likely becomes exposed in an environment
of strengthening growth, which should in principle favour higher
yielding assets, but would in practice be dominated by excess
positioning.”

And as Draghi returns 10 months on, there’s little doubt that he and his U.S. and Japanese peers have succeeded in convincing financial investors of central bank doggedness at least. Don’t fight the Fed and all that – or more pertinently, Don’t fight the Fed/BoJ/ECB/BoE/SNB etc… G4 stock markets are surging ever higher through the Spring of 2013 even as global economic data bumbles along disappointingly through its by now annual ‘soft patch’.  Looking at the number tallies, total returns for Spanish and Greek equities and euro zone bank stocks are up between 40 and 50% since Draghi’s showstopper last July . Italian, French and German equities and Spanish and Irish 10-year government bonds have all returned about 30% or more. And you can add 7% on to all that if you happened to be a Boston-based investor due to a windfall from the net jump in the euro/dollar exchange rate. What’s more all of those have outperformed the 25% gains in Wall St’s S&P 500 since then, even though the latter is powering to uncharted record highs. And of course all pale in comparison with the eye-popping 75% rise in Japan’s Nikkei 225 in just six months!! Gold, metals and oil are all net losers and this is significant in a money-printing story where no one seems to see higher inflation anymore.

But with both Fed and BoJ pushes getting some traction on underlying growth and the euro zone economy registering it’s 6th straight quarter of contraction in the first three months of 2013, maybe Draghi’s big task now is to convince people the ECB will do whatever it takes to support the 17-nation economy too and not only the single currency per se. Last year’s pledge may have been a necessary start to stabilise things but it has not yet been sufficient to solve the economic problems bequethed by the credit crisis.

Coincidence or not, Draghi speech on Thursday is flanked by keynotes from his monetary allies. Fed chief Bernanke  speaks on Saturday and then to testifies to the congressional Joint Economic Committee on Wednesday, BoJ head Kuroda holds a press conference after the bank’s policymaking meeting ends on Thursday and outgoing BoE governor King speaks Friday. G20 sherpas meet in Russia this weekend, while EU leaders meet in Brussels on Wednesday. The big economic data set-piece of the week will be critical flash global PMI readings for May – is business finally pulling out of the early year funk or is confidence still evaporating?

Main economic events and data releases for next week:

G20 sherpas meeting in St Petersburg Sat/Sun

Fed’s Bernanke speech on long-run economic prospects Sat

Italy March Industry orders Mon

Irish PM Kenny in Boston Mon

Japan 40-yr JGB auction Tues

UK April inflation Tues

Japan April trade Weds

BOJ news conference after latest policy meeting Weds

BoE minutes Weds

EU summit Weds

German 10-yr bund auction Weds

US April existing home sales Weds

Fed’s Bernanke testifies to Joint Economic Committee of Congress Weds

FOMC minutes Weds

Global May flash PMIs Thurs

Spain govt bond auction Thurs

UK April retail sales/Q1 GDP revision Thurs

ECB’s Draghi speaks in London Thurs

EZ May consumer confidence Thurs

US April new homes sales/March house prices Thurs

SAfrica rate decision  Thurs

German May Ifo sentiment Fri

French May business climate Fri

Italy May consumer confidence Fri

US April durable goods orders Fri

BoE’s King speaks in Helsinki Fri

With governments awash with debt and furiously selling new securities to fund bloated budget deficits, the idea of a bond shortage on the marketplace may sound puzzling.

Yet not only is “quantitative easing” by the world’s major central banks sucking benchmark bonds out of the system, new regulations to strengthen banks and derivatives markets that effectively ring-fence bond holdings at commercial banks has raised concerns about a lack of bonds to lubricate the system.

And while U.S. Federal Reserve Chairman Ben Bernanke claims to be monitoring any sign of a reckless “reaching for yield” among investors as government and corporate borrowing costs sink around the globe, the skew in supply and demand for bonds speaks volumes.

JPMorgan estimates that the world’s central banks and commercial banks alone now hold some $24 trillion worth of bonds – or 55 percent of the entire $44 trillion universe of government, asset-backed and corporate bonds as captured by Barclays Multiverse Global Bond Index.

What’s more, these players hold more than two thirds of the government bond subset, which amounts to about $25 trillion.

“That’s why we are in such a depressed bond yield environment,” said JPMorgan economist Nikolaos Panigirtzoglou.

Cumulative bond buying since 2008 by four major central banks alone – the Fed, Bank of Japan, European Central Bank and Bank of England – reached more than $4 trillion this year. Added to existing holdings, that brings their total to $5.2 trillion.

With new Fed purchases of Treasury bonds set to top $1 trillion in 2013 and Bank of Japan bond buying more than half that amount, the year-end total will be about $6.5 trillion.

And as both the Fed’s and the Bank of Japan’s bond buying will exceed new bond sales by their governments by at least $100 billion this year, there will be fewer bonds around this year than last despite all the new debt sales.

Add to that $8.7 trillion of bonds estimated to be held by central banks in China and around the globe to bank their hard cash reserves, and $10 trillion of bonds held by commercial banks in the G4 developed economies to hold down risk-weightings on their assets – then there’s not much left for everyone else.

With banks viewing Treasury bonds as a direct substitute for cash or “excess reserves” with slightly higher returns, the remaining bonds in the banking system get passed around like “hot potatoes” and yields converge, said Panigirtzoglou.

The central point of JPMorgan’s number crunch was to show the remaining $20 trillion of the bond universe, held by non-banks such as pension, insurance, mutual and hedge funds, means the investment world is unlikely to be as overweight bonds as many had assumed. That total, they reckon, would only amount to about 30 percent of their combined bond and equity holdings.

And this tallies with asset managers, who are already eschewing what they consider to be scarce and over-expensive government debt in favour of often higher-yielding if lower quality corporate and emerging market bonds.

“Bizarrely, despite all this debt issuance there is a shortage of bonds,” said Alan Higgins, Chief Investment Officer at British private bank Coutts, adding there were plenty of signs of what he called “leakage” within the more conservative fixed income funds to higher-risk securities as a result.

BOND DROUGHT?

What’s more, this bond drought on the investment markets has added to growing concern about a shortage of high quality collateral – typically top-rated bonds – pledged and repledged within the financial system to raise cash.

For example, the latest meeting of the U.S. Treasury and bond market participants – the quarterly Treasury Borrowing Advisory Committee – discussed the problem late last month.

It concluded that with AAA- and AA-rated sovereign borrowers selling an estimated $2 trillion of new bonds annually, supply of this high-quality collateral would probably be two to three times demand in normal conditions. However, it said demand could well approach $10 trillion in “stressed markets”.

This concern about having enough collateral available to generate credit within the financial system refocuses on a central aspect of the banking crisis and its aftermath.

International Monetary Fund economist Manmohan Singh has in a number of papers over the past year estimated that interbank mistrust and banks’ narrowing definition of acceptable collateral reduced the re-use or re-pledging rate by the big banks to about 2.4 times from 3.0 before the crisis, involving a drop of up to $5 trillion in the cash generated by the banks.

That’s more than the cash injected by the central banks’ bond-buying programmes since 2008 and for many this reduced “velocity” of cash-like collateral within the system helps explain why credit in the economy at large is still stalled.

For Singh, it’s the rise in ‘idle’ or ‘silo-ed’ collateral due to institutional ring-fencing – QE, new bank capital and derivatives markets regulation and central bank reserve management and the like – that policymakers now need to watch closely.

(Editing by Ruth Pitchford)

With governments awash with debt and furiously selling new securities to fund bloated budget deficits, the idea of a bond shortage on the marketplace may sound puzzling.

Yet not only is “quantitative easing” by the world’s major central banks sucking benchmark bonds out of the system, new regulations to strengthen banks and derivatives markets that effectively ring-fence bond holdings at commercial banks has raised concerns about a lack of bonds to lubricate the system.

And while Federal Reserve Chairman Ben Bernanke claims to be monitoring any sign of a reckless “reaching for yield” among investors as government and corporate borrowing costs sink around the globe, the skew in supply and demand for bonds speaks volumes.

JPMorgan estimates that the world’s central banks and commercial banks alone now hold some $24 trillion worth of bonds – or 55 percent of the entire $44 trillion universe of government, asset-backed and corporate bonds as captured by Barclays Multiverse Global Bond Index.

What’s more, these players hold more than two thirds of the government bond subset, which amounts to about $25 trillion.

“That’s why we are in such a depressed bond yield environment,” said JPMorgan economist Nikolaos Panigirtzoglou.

Cumulative bond buying since 2008 by four major central banks alone – the Fed, Bank of Japan, European Central Bank and Bank of England – reached more than $4 trillion this year. Added to existing holdings, that brings their total to $5.2 trillion.

With new Fed purchases of Treasury bonds set to top $1 trillion in 2013 and Bank of Japan bond buying more than half that amount, the year-end total will be about $6.5 trillion.

And as both the Fed’s and the Bank of Japan’s bond buying will exceed new bond sales by their governments by at least $100 billion this year, there will be fewer bonds around this year than last despite all the new debt sales.

Add to that $8.7 trillion of bonds estimated to be held by central banks in China and around the globe to bank their hard cash reserves, and $10 trillion of bonds held by commercial banks in the G4 developed economies to hold down risk-weightings on their assets – then there’s not much left for everyone else.

With banks viewing Treasury bonds as a direct substitute for cash or “excess reserves” with slightly higher returns, the remaining bonds in the banking system get passed around like “hot potatoes” and yields converge, said Panigirtzoglou.

The central point of JPMorgan’s number crunch was to show the remaining $20 trillion of the bond universe, held by non-banks such as pension, insurance, mutual and hedge funds, means the investment world is unlikely to be as overweight bonds as many had assumed. That total, they reckon, would only amount to about 30 percent of their combined bond and equity holdings.

And this tallies with asset managers, who are already eschewing what they consider to be scarce and over-expensive government debt in favor of often higher-yielding if lower quality corporate and emerging market bonds.

“Bizarrely, despite all this debt issuance there is a shortage of bonds,” said Alan Higgins, Chief Investment Officer at British private bank Coutts, adding there were plenty of signs of what he called “leakage” within the more conservative fixed income funds to higher-risk securities as a result.

BOND DROUGHT?

What’s more, this bond drought on the investment markets has added to growing concern about a shortage of high quality collateral – typically top-rated bonds – pledged and repledged within the financial system to raise cash.

For example, the latest meeting of the U.S. Treasury and bond market participants – the quarterly Treasury Borrowing Advisory Committee – discussed the problem late last month.

It concluded that with AAA- and AA-rated sovereign borrowers selling an estimated $2 trillion of new bonds annually, supply of this high-quality collateral would probably be two to three times demand in normal conditions. However, it said demand could well approach $10 trillion in “stressed markets”.

This concern about having enough collateral available to generate credit within the financial system refocuses on a central aspect of the banking crisis and its aftermath.

International Monetary Fund economist Manmohan Singh has in a number of papers over the past year estimated that interbank mistrust and banks’ narrowing definition of acceptable collateral reduced the re-use or re-pledging rate by the big banks to about 2.4 times from 3.0 before the crisis, involving a drop of up to $5 trillion in the cash generated by the banks.

That’s more than the cash injected by the central banks’ bond-buying programs since 2008 and for many this reduced “velocity” of cash-like collateral within the system helps explain why credit in the economy at large is still stalled.

For Singh, it’s the rise in ‘idle’ or ‘silo-ed’ collateral due to institutional ring-fencing – QE, new bank capital and derivatives markets regulation and central bank reserve management and the like – that policymakers now need to watch closely.

(Editing by Ruth Pitchford)