Fed tapering moving hot money from EM to Europe

Today’s commentary

Summary: If you look at the last two posts on this site from Marc Chandler and from Sober Look the connection between Fed tapering and money flows is clear. Hot money is flowing out of emerging markets and into Europe. Below I explain why this is happening and what market warning signs to look for. 

First, let me quote from Marc’s post:

The US dollar stands at the fulcrum. Investment flows are leaving emerging markets, with currencies from Brazil, India, Indonesia and Mexico being hit the hardest over the last few sessions. The MSCI Emerging Market Index is off 4.5% over the past five sessions and the rout continues.

Falling commodity prices, country specific challenges, as in India, Indonesia, Brazil, and Turkey, coupled with anticipation that the days of low interest rates in the high income countries are largely behind us, is spurring a reversal of fortune for the emerging markets, as an asset class. Those countries with current account deficits are particularly vulnerable to this switch.

Reports indicate that those funds are not moving to the US, where expectations for Fed tapering next month running high, lifting the 10-year yields to almost 2.90% yesterday. Rather, reports indicate that Europe has been the biggest beneficiary of inflows over the past week or two. In fact, it may not just be a flow from the emerging markets into Europe, but there also has been an outflow from US fixed income and equity funds too.

It seems to reflect two related forces. First, is market positioning. It does appear that many global investors were under weight Europe, preferring US and Japanese equities through much of the first half and into Q3. Second, this left many investors ill-prepared for the European reflation story, which has gained traction over the past couple of weeks.

The Bundesbank monthly yesterday, highlight the conditionality around the ECB’s forward guidance is typically BBK behavior, and might not have been a significant factor if it were not for market conditions and positions. Specifically, the BBK has once again, seemingly gone out of its way, to outflank the ECB.

Various measures by the ECB in response to the crisis, from SMP to OMT, including Greek aid and its funding gap, bank supervision, and now the forward guidance, the BBK appears to have been consistently overruled (formally or informally). The BBK does not let it go and accept the compromises as part and parcel of monetary union. Indeed, the BBK’s criticisms of the ECB policies shows monetary union itself is far from complete.

The story here is the one I have been foretelling for months now and highlighted Friday – the European reflation trade is on. Europe’s sinking economy was unsustainable politically and socially and so the Europeans moved to a more accommodative stance, something that was fully supported by the Germans due to Germany’s upcoming election. The German ruling coalition needs a reflation story to bolster their chances at the polls. The move to backloaded austerity has been supported by the ECB in the guise of forward guidance. Think of this as monetisation. The markets are now onto this trade and the hot money has flowed in to benefit from it.

Meanwhile, in EM, China’s incipient rebalancing is proceeding apace, with stories of China forming bad banks to clean up the non-performing loan mess. A Naked Capitalism headline today declares, “China prepares to bail itself out” with an article that is worth a read on the situation. I also recommend Michael Pettis’ piece on China’s urbanization as well to understand why urbanization is no panacea for the slowing growth that rebalancing implies. As the Chinese are taking infrastructure spending and fixed capital investment down a notch to effect this rebalancing this has hit the industrial commodities sector hard. That is bad for emerging markets. And so hot money is flowing out of EM.

Sober Look notes the following then:

India and Brazil are struggling to regain control of their currencies as both the rupee and the real touch new lows (all-time record for the rupee). It is remarkable how violent the corrections have been in just the past 3 months.

For those who don’t watch these currencies on a daily basis, these sell-offs seem to happen in spurts – almost at random. But there is a pattern here, particularly in the past few months. Investors are dumping these currencies during periods of higher expectations of the Fed’s slowing its securities purchase program. The evidence for the pattern is in the correlation between these exchange rates and the US treasury yields. Since Bernanke’s first comments on slowing the securities program, currency weakness consistently corresponds to higher US yields resulting from sharper taper expectations (see post).

The prospects of higher long-term interest rates resulting from the Fed’s taper is forcing investors out of emerging markets – and these two nations are feeling the brunt of this “rotation”. To be sure, we have no way of knowing if this would have still occurred if the Fed had not initiated QE3 a year ago. But the severity and the speed of these corrections would suggest that this is one of those unintended consequences of applying and then trying to exit an aggressive monetary stimulus program within highly interconnected capital markets, operating in a global economy. This has not been a part of the FOMC’s forecast…

Basically this is the flipside of the EM hot money currency wars story. Where QE was causing hot money to flow out of the US and into EM, now tapering QE is causing the hot money to leave EM, especially commodity-sensitive EM, and flow out to Europe where the reflation play is getting started. So, this trade is Europe-buliish and EM-bearish. It is also slightly bearish for Treasuries, though I think the downside is capped and purely short-term. How long will this go on? It’s hard to say given how violent the move is but we should be on the lookout for this breakdown becoming a crisis since we are entering that time of year where we typically see this kind of volatility. The areas to watch are Brazil, India and Europe.