When Federal Reserve Chairman Jay Powell said in December that the central bank's reduction of its balance sheet was on autopilot, global markets balked. When he later walked back that statement at the annual meeting of the American Economic Association and assured that the Fed “wouldn’t hesitate” to alter its balance sheet policy if needed, investors cheered.
Few markets have gyrated on the comings and goings of this so-called "quantitative tightening" as wildly as emerging markets. As primary beneficiaries of its counterpart, quantitative easing, in the aftermath of the financial crisis, and the subsequent reach for yield as interest rates in developed economies fell, the fate of emerging markets is tethered quite closely to decisions made by the Federal Reserve.
Despite Powell's new promise for patience when it comes to unwinding the balance sheet, an outright pause appears unlikely. For emerging markets, which have already felt substantial pain this year from this shift, the situation could deteriorate further.
Accelerating in earnest from 2009, the Fed snapped up US Treasuries to inject liquidity into the system and mortgage-backed securities to prop up demand for what were once considered safe assets. This helped to ease financial conditions and borrowing costs as prices rose and interest rates fell. Central banks across emerging markets followed suit, as did the Bank of Japan and European Central Bank. As Matt King of Citi shows in the below chart, that process has begun to taper off in some economies, and in the US, reverse altogether. The pace is set to quicken this year:
What this level of support helped to do was to allow non-financial corporations to pile on debt very cheaply. And that they did. Private credit in China and across emerging markets ballooned. Businesses in developed markets imbibed as well, but to a much smaller degree. Now, with central banks rolling off their balance sheets, King points out that private credit has started to shrink, too:
As with most binges, the come down is never easy — a reality of which many across the emerging world are now acutely aware. Given that "credit creation has been the most important driver of asset prices for decades," according to King, the net effect on global economic growth and equity markets has been disruptive to say the least. Take a look at the change in global data versus credit creation in both the public and private sector. As credit creation has pulled back, economies have stumbled, per King:
A similar dynamic has played out in global equity markets, with the MSCI World Index plunging nearly 8 per cent since January 2018.
China and emerging markets have borne the brunt of this unwinding not only because they binged the most on the giant pool of cheap money in the years since the crisis, but also in large part because of what such an unwind means for the US dollar, as Citi's Calvin Tse points out:
...if one thinks of the price of any asset as its relative supply versus demand, as the Fed shrinks its balance sheet, the supply of global dollars will also shrink. And this supply of USDs has proven to be a strong predictor of USD performance in recent years.
The dollar rally of 2018 surprised many, but none more so than emerging markets. On a trade-weighted basis, the greenback surged just shy of 8 per cent last year, exacerbating currency crises not only in Argentina and Turkey, but other economies with large dollar-denominated debts.
As the Fed continues to shrink its balance sheet and sop up dollar liquidity, Citi's Tse reckons the greenback has further room to run even if the Fed does slow down the pace of interest rate increases, as it signalled it might do per the minutes of its most recent meeting:
Still, a full stop on either interest rate increases or quantitative tightening appears unlikely. "While central banks are becoming more sympathetic to markets," says Citi's King, "the hurdles towards stopping the balance sheet reduction or easing monetary policy is very high. They may become less hawkish, but they are a long ways away from becoming dovish or easing outright."
Perhaps emerging markets haven't seen the bottom just yet.
Related Links:
Global leverage, examined — FT Alphaville
A dollar rally few are prepared to call time on — FTGlobal liquidity is drying up — FT Alphaville
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