The extent to which the Fed’s decision to maintain its $85 billion of monthly asset-purchases surprised investors can be seen in the market reaction, with the dollar dropping sharply, yields tumbling and risky assets rallying. FX vols also traded lower, suggesting the carry trade might be becoming more attractive once again.
Ben Bernanke, Fed chairman, delivered a statement and set of economic forecasts that suggested the central bank was no nearer to normalizing monetary policy, emphasizing that tapering of asset purchases depends on how the economy develops.
Bernanke also cited the tightening of financial conditions in recent months, which he said might hamper the US economic recovery.
That is somewhat ironic given it was Bernanke’s comments on May 22, when he first aired the prospect the Fed might consider tapering its asset purchases, which have driven rates higher.
Indeed, while the Fed’s decision might be welcomed by EM central banks – such as those in Brazil, India and Indonesia, that have seen their bond markets dive and currencies sell-off since US monetary normalization was first mooted in May – there might be mixed feelings.
That is especially true given the extent to which EM central banks have been forced to run down their FX reserves in an attempt to stabilize their currencies. Société Générale, for example, estimates EM central banks sold $105 billion and €53 billion since the rout in EM currencies started in May.
| Central banks sold $105 billion and €53 billion during EM crisis |
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Chris Turner, head of FX strategy at ING Financial Markets, says it now appears Bernanke’s comments in May were some kind of tapering stress test, and one which the markets seemed to have failed.
“Authorities in emerging markets, having lost valuable FX reserves and now facing higher inflation and lower growth, must be fuming and feel they have been unwittingly used in a Fed experiment of hypothetical tapering,” he says.
Still, the chart below shows the sell-off in selected EM currencies since Bernanke’s comments in May. That would seem to suggest that the Indonesian rupiah, Indian rupee and Brazilian real could enjoy a reprieve in the wake of the Fed’s decision.
| Percentage change versus dollar since May 21, 2013 |
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That said, all those currencies have been underperforming for domestic reasons as well, such as belated adjustments to terms of trade decline, growing current-account deficits and, in Brazil, a mistrust of economic policy in the run-up to an election year.
Nevertheless, it has been troubled deficit-ridden EM markets that have been given some breathing room by the Fed’s decision. Countries that were hit hardest during the summer sell-off have rallied most since the announcement, with the Indonesian rupiah, Indian rupee, Brazilian real and Turkish lira all about 3% stronger against the dollar.
From the point of view of these EM countries, however, the Fed decision is best viewed as a temporary reprieve rather than a stay of execution, according to Neil Shearing, chief emerging markets economist at Capital Economics.
“For a start, the Fed still looks set to start scaling back its asset purchases at some point over the next few months, even if this process is more gradual than previously seemed likely,” he says.
“Indeed, the uncertainty created by the decision not to taper might end up generating further bouts of market volatility, which in turn might create new problems for EM policymakers.”
Certainly, one implication of the decision for markets generally is that the Fed’s credibility has taken a further knock.
Once upon a time, the Fed prided itself on managing expectations, such that a Fed policy statement barely moved financial markets.
The degree of market reaction to this decision shows how far the Fed has moved away from that position, despite its recent efforts to improve communications and increase transparency.
Indeed, Marc Chandler, head of currency strategy at Brown Brothers Harriman, notes Bernanke said in his post-decision press conference that the Fed was pleased with the market reaction to its statement – suggesting its failure to communicate to the market might have been desired.
However, Chandler notes there are good and bad surprises.
“The market reaction so far suggests this was a good surprise, but we think there are potential negative implications down the road,” he says.
“If excesses and irrational exuberance build up yet again in the financial markets, the eventual tapering decision may be more painful for markets than it needs to be.”
In other words, EM currencies might be rallying over a perceived stay of execution from Fed tapering, but the day of reckoning might have been potentially made more painful by the central bank’s decision.
Indeed, Shearing notes that the structural problems that put several EM markets in the firing line over the summer have not gone away.
Current-account deficits, after all, remain a problem in India, Indonesia, Brazil, Turkey and South Africa, he notes.
Some suggest the Fed’s decision to delay tapering creates a window for structural reform in EM economies, but Shearing is sceptical.
“Undoubtedly, structural reform holds the key to reviving growth in many parts of the emerging world, but policymakers have hardly been scurrying into action in recent months,” he says.
“We can’t blame the Fed for everything.”
History suggests some rallies, potentially such as those just triggered in some EM currencies by the Fed, provide investors with a selling opportunity.