For about three hours last Wednesday the goals of the Ben Bernanke led Fed were achieved when the NASDAQ market stopped trading due to a technical glitch. With no quotes available, investors were not able to sell – or buy – and the level of the NASDAQ market was stuck at a semi-permanent plateau. Finally, a way to unwind QE without all that nasty market reaction! Now if Bernanke can just get the NSA to figure out a way to shut down the bond market for a while, a workable plan for ending QE might just come into focus. Just close the markets, put the NY Fed on hiatus and call it a year.
Unless that is the actual plan it seems highly unlikely that an unwinding of the Fed’s QE program can be accomplished without some turmoil. The mere hint of a step toward a potential end to the Fed’s bond buying has already sent India and Brazil into near crisis (with India maybe nearer) as capital that was once flowing in has started flowing out. Or at least that is the popular theory. Scapegoating the Fed for all the world’s ills is usually a pretty good bet although there are any number of good reasons investors might have grown a bit more skeptical about the growth prospects in emerging markets recently. Certainly capital is flowing out of any number of places that were previously considered sure bets. Brazil’s currency may have had a tough time lately but it sure isn’t alone. Australia and a bevy of other countries dependent on Chinese demand for commodities have recently seen their currencies slip.
It isn’t just countries that supply China that are having problems though. India and Turkey are not generally dependent on Chinese growth but both have seen big drops in their currencies and stock markets. The emerging market boom was mostly about a flood of cheap capital – due to easy Fed policies – from the developed world which created a credit boom in the target countries. Now that the capital inflows have turned to outflows their economies are suffering and companies that were foolish enough to borrow in foreign currencies are facing debts they can’t repay. The reason for the outflow is really irrelevant though and while it could be the Fed’s tapering hints, it could also just be an acknowledgment that these countries aren’t likely to grow at the rates they have in the past.
Whatever the cause, reversing these flows and getting investors to return is not going to be easy. I’ve seen a number of comments recently that this won’t turn out like the last Asian crisis because emerging market countries have built up large dollar reserves during the boom years but if the capital keeps coming out that won’t matter. In fact, the large reserves may sow the seeds of further destruction. There is a widely held belief that the US bond market has been selling off because of the Fed’s taper talk, but a better answer may be found in these emerging market reserve accounts. The reserves have been invested primarily in US Treasury bills, notes and bonds. As their currencies drop, emerging market central banks use the reserves in an attempt to prop up their currencies. Using them means selling Treasuries – and the dollars those sales generate – to buy their own currencies. But in doing so, they drive up US interest rates which has a negative effect on US growth. And lower US growth means lower growth in emerging markets and further reason for capital to flee. I think that is called a negative feedback loop.
Whether it is due to the Fed’s talk of tapering or other reasons, higher interest rates do seem to be having a negative impact on a US economy that was already struggling. Most vividly, the report on new home sales last week was a disaster with sales down 13.4% and previous months also revised lower. While we haven’t seen a similar reaction in existing home sales – yet – that is likely due to the fact that existing home sales have been driven by cash, institutional buyers. New home sales, in contrast, are generally for real buyers who intend to occupy their new home and need a mortgage to do so. With incomes stagnant, households may not be able to overcome the rise in carrying costs (rising property taxes from appreciating home values is another less talked about issue). A more direct impact on the economy is coming from the banks that originate the mortgages. Wells Fargo and Bank of America have recently announced layoffs in their mortgage operations due to dwindling demand, primarily for refinance.
As I said last week, there is a limit to how high interest rates can go before the US economy rolls over and resumes the fetal position. If I’m right about EM as the source of selling in the Treasury market, a further slowdown in the US economy may not be sufficient to arrest the rise in rates. What we don’t know yet is how the Fed will respond to what is going on in Brazil, India and other EM countries. Will they postpone tapering due to the turmoil? They might although Bernanke has said before that these countries have the tools to deal with the situation. Frankly, whether the Fed tapers or not may be irrelevant if the emerging markets continue to implode. Bernanke has obviously been concerned that QE is blowing bubbles here in the US but that problem may take care of itself. Continued rising rates and reduced growth expectations around the world do not seem ideal conditions for a continuation of the bull market in US stocks.
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