Daily commentary
While the emerging markets are getting a bit of a reprieve today, it bears noting that the move to so-called safe haven assets and currencies has begun. This suggests to me that George Magnus’ warning about this emerging markets crisis must be heeded. I believe a key component to the selloff’s ending will be better economic data out of China as the interest rate hikes taken in several EM countries have not had a beneficial effect. Bonds will continue to rally until the EM crisis has been decisively dealt with. More thoughts below.
Is it a crisis?
I am still on the fence regarding the severity of the emerging markets crisis. My general view is that the economic outlook in the new G3, the US, Europe and China, is positive enough to overcome ill effects from the emerging markets. But the view by George Magnus that a crisis is brewing has put me on alert. Moreover, all three G3 economies have weaknesses that have left us vulnerable to a negative feedback effect in equities markets. In the US, peak growth is behind us in my view, growth has been bolstered by inventory builds as domestic final sales support 2% growth, not 3% growth and markets are already overvalued. In Europe, the recovery is only in its infancy. And in China, an epic credit bubble has to be contended with while the Chinese economy rebalances away from export- and investment-led growth.
Safe haven move
What we have seen thus far then is that poor data out of the US and China yesterday intensified fears coming from the emerging markets and started a move to safe haven asset classes.
For example, the US Treasury bond is now selling below 2.60% and has retraced all of the increase in yield over the last three months.
(click on link for graph below)
The ten year is now below 2.60% after the Fed has tapered twice. We’re back to Nov levels pic.twitter.com/ALah08tisx
— Edward Harrison (@edwardnh) February 3, 2014
Of course, I think there is more to the Treasury move than just safe haven investing. Yields have actually risen during periods of QE on the promise of recovery.
Yields are now falling because of concerns of slower growth. The Fed’s tapering is de facto tightening. 2013 was the equivalent of 1994 in terms of bond routs for this reason. And the concern now that EM is falling and data have been soft (74,000 non-farm payrolls, 51.3 ISM) is that this is a harbinger of economic weakness, and that the Fed will continue to taper asset purchases, signalling policy normalization despite the economic weakness. And investors were caught out by the weakness as everyone was positioned for a curve steepening according to Treasury-bullish Jeff Gundlach. Tim Duy sums up my view:
Bottom Line: The Fed is once again in a familiar place. They try to pull back on policy, and markets tumble. Tightening has repeatedly proved to come too early; one wonders if the Fed would have had to keep doing more if they didn’t keep promising to do less. If history is any guide, they will eventually reverse course. But that same history would suggest that they need to see conditions deteriorate further before they act.
But, on the safe haven front, other asset classes are getting bid too. Izabella Kaminska at FT Alphaville noted yesterday that capital seems to be coming back into the eurozone as evidenced by the difficulty the ECB is having in sterilizing its operations. And this view is bolstered by the decrease in eurozone periphery sovereign bond yields. So Greek, Portuguese, Spanish, and Italian bond yields are benefitting from a ‘relative’ safe haven bid for euro-denominated assets. And given the yield pickup over Bunds, these bonds are bid because of the now implicit backstop that the ECB’s OMT represents.
In the US, the same phenomenon – of riskier asset classes tightening and not selling off can be seen. Last week when commenting on high yield and high risk investing in EM and junk debt. I noted that high yield debt in the US was not selling off, yet EM debt (and equity) was selling off.
“If you look back to one year ago – pre-tapering – what you see in terms of US fixed income is a picture of incredibly low sovereign yields and low but not extremely low corporate risk spreads. Emerging markets were doing well. The 10-year Treasury was trading at 1.981%. The AAA/BAA credit spread was 95 bps, and the JP Morgan Emerging Market debt spread 244 bps.
“Today, the picture is very different on the fixed income scene. The 10-year Treasury is now trading at 2.79%, off highs over 3%. The AAA/BAA credit spread is even lower at 66 bps and the JP Morgan Emerging Market debt spread has gone up to 376 bps. US yields are way up as are emerging market yields but spreads to junk are down to incredibly low levels. This picture is not fundamentally about a risk-off trade where people are rotating out of riskier asset classes due to the rise in US interest rates. Otherwise junk would be selling off – and its not. Instead, we should see what is happening in EM as something fundamentally about EM and not about US monetary policy.”
Today, the AAA/BAA credit spread is down to 64 bps and the JP Morgan Emerging Market debt spread is 405 bps. So EM has continued to sell off, yet high yield in the US is tightening. This is indicative of hot money leaving the emerging markets for safe havens in Europe, the US and elsewhere.
The reason you saw the Casey Research piece on gold today proclaiming now is the time to buy gold is because I think gold could catch a bid here as a safe haven. I don’t agree with everything in that article. However, the dynamics have shifted enough to move me from my neutral to bearish stance on gold in November to a neutral to positive stance today. I think the EM crisis could be a catalyst for gold as a safe haven.
The workout phase
Where does that leave us then?
The emerging markets are on their own. There is no policy coordination coming. Janet Yellen is not going to stop tapering because of what happens in emerging markets. So emerging markets have to do what they can to stop the hot money flows from destabilizing the real economy.
Let’s look at this through the impossible trinity lens. According to this well-known idea you cannot have fixed exchange rates, free capital movement and an independent monetary policy at the same time. One of the three has to give. What is happening now is that, with China slowing, commodities declining and the Fed tapering, currencies in EM are depreciating so rapidly in emerging markets as hot money flees that it is causing financial markets to sell off violently. This is having a very negative affect on the real economy in terms of investment in economies with large external funding needs and it is also leading to a generalized increase in inflation. So EM central banks want the depreciation to stop. They are thus trying to fix their exchange rates artificially by intervening in currency markets
But if the EM countries are fixing their exchange rate to prevent capital outflows, they cannot have a lax monetary policy in the face of tightening in China and the United States. Countries like Argentina, which are the weakest in terms of foreign currency reserves, gave up the ghost on the exchange rate. Argentina has devalued. But once the intervention fails, invariably the country in turmoil turns to ‘non-independent’ monetary policy i.e. rate hikes. We see this in South Africa, Turkey, Brazil, India and elsewhere. Raising rates to keep the currency up makes matters worse because it reduces the demand for credit when the supply has already been restricted. This will be a decelerator for the economy.
So to review, the tightening in the US and China causes money to flow out of EM. The emerging markets try to fix the currency to keep the outflow from destabilizing the economy. They run out of reserves and thus tighten policy to mimic the developed economy policy thinking this will help. It doesn’t help everywhere. In this case it has helped in India but the crisis will continue. After intervening in foreign exchange and failing, and then ceding monetary policy to external events and failing, capital controls will eventually come to the weakest countries. That’s how I see it playing out.
The problem here, of course, is the monetary system. As I wrote when explaining the causes of the crisis:
“Ultimately, this is what happens when you have unfettered capital flows centered around a monetary system that lacks any sort of mechanism to stem external imbalances. The dollar standard post-Bretton Woods is a flawed monetary system, all the more so because the accumulation of US dollars as reserves guarantees current account problems between the US and its main trading partners. Let’s hope the current crisis settles down soon. If it doesn’t, the overdue correction in equities will be on us and bonds will outperform.”
We are almost at an equity market correction point (10% down) and bonds are way up. But the crisis is probably not over. I see this in much the way the euro crisis was. The weakest links are attacked until they adopt capital controls or their economy falls apart. And then it is on to the next weakest link and so on. Eventually, what was a manageable crisis then becomes a real crisis and contagion would be everywhere – including in high yield sovereign debt in Europe and high yield corporate debt in the US. What we need to see is some sort of policy coordination to prevent this scenario from playing out. But there is no indication that policy will be coordinated. Instead, we are seeing a currency wars kind of drama play out in which it is every nation for itself until a crisis hits home. The US will not reverse course because the US has its own froth to worry about.
China remains the only out here. With growth weakening, it isn’t long before the Chinese government reverses its rebalancing and tightening mantra. If China delays long enough, contagion will be to great to overcome and the emerging markets crisis will feed on itself regardless of what the Chinese do. The next few weeks will be interesting.