Times must be tough over at Constitution Avenue. Fed Chair Yellen is walking a fine line, balancing hawkish statements from the likes of Vice Chair Fischer with dovish remarks from governors such as Evans and Dudley. The market is convinced the Fed moves rates by year-end. If that happens, the yield curve will flatten and mid to long term rates will fall. This is the Fed’s quandary. But the way the US – and the rest of the world – is trending, this might be a moot discussion. It’s hard to hike rates in the shadow of 0.2% annualized GDP growth.
Before the 2008 crisis, European commercial banks were big lenders to emerging market (EM) corporates, often in local currency. Post crisis, Europe doesn’t do much EM lending (or any lending, for that matter).
European Credit Growth Rebounding, But Still Negative (source: Bloomberg, Cabezon)
Nature abhors a vacuum. On the back of aggressive QE, many US investors found themselves crowded out of the domestic credit markets. Capital has found its way into EM. But unlike European banks, these investors wanted external, USD-denominated debt. Issuance has exploded since 2008.
5X Or More Increase in External Debt (source: Bloomberg, World Bank, Cabezon)
Borrowing in dollars when you are an EM corporate – especially when US rates are low – isn’t necessarily a bad thing as long as you can buy dollars to pay your debt back. EM dollar borrowers have come under stress lately on the back of a strong dollar rally. The past month has given some respite, but the trend is clear. If the US raises rates while most everyone is easing, the dollar will gap higher. That spells trouble for those EM dollar borrowers.
Back in May of 2013, the market endured what is now called “the taper tantrum”. Bernanke talked about exiting QE for the first time (at least, the first time for real). The dollar rallied against EM currencies, and US yields rose. Investors felt that the divergent path of interest rates would pull money out of emerging markets, and no one wanted to be the last one at the party. Despite a repatriation of dollars, treasuries sold off on the concern over an imminent Fed hiking cycle.
Treasuries and EM Currencies Diverged in the Taper Tantrum (source: Bloomberg, Cabezon)
Many market pundits feel that the taper tantrum prepared emerging markets for the coming Fed hikes and we won’t see the same price action this time around. They are right that things will be different, just not the way they expect. If the Fed hikes, EM FX will collapse, pressuring many EM dollar borrowers into default. Investors won’t wait for this, however, and will pull capital back to a US market already saturated with massive buying spurned on by Europe and Japans quantitative easing (QE) programs. Treasury rates will fall – not rise – and I believe the period will be affectionately termed “the Fed funds fiasco.” But this whole discussion might be moot, given the trend in US macro data.
Yields Were Trending Lower Before Negative Data (source: Bloomberg, Cabezon)
US data has been trending negative, capped by an anemic 0.2% Q1 GDP print. Most economists attribute this to some combination of the weather, the West Coast port strike, and animal spirits. But the real culprit here is the dollar. As I’ve written about before, the rally in the dollar over the past six months is akin to a 200 bps hike in Fed Funds. We’re seeing the impact on everything from PPI to earnings to growth.
The Dollar is Weighing on PPI and Earnings (source: Bloomberg, Cabezon)
The dollar rally is not going away, irrespective of what the Fed does. The ECB is pushing QE to new levels with aggressive bond buying and negative rates. Money is fleeing Europe – and the Euro – faster than a fat kid chasing cake. And it’s headed to the US. The Fed hiking only accelerates – and magnifies – this move.
If you were a European pension manager, would you rather own 10-year bunds, in euros, yielding 35 bps – or 10-year US Treasuries, in dollars, with a healthy 2% yield? The Europeans have been so aggressive, they’ve out-QE’d Japan. And this doesn’t bode well for the Japanese.
German Rates Push Below Japan, the Yen Gains on the Euro (source: Bloomberg, Cabezon)
As Europe pushes rates to negative territory, the previously unthinkable has happened. The Euro – not the Yen – has become the favored funding currency. The Yen has appreciated against the Euro, and has traded sideways against the dollar. With growth slowing, inflation trending back below zero and China about to embark on its own QE program, Japan will need to embrace negative interest rates to keep up in this global easing game.
Still Likely By December, But Not 100% (source: Bloomberg, Cabezon)
After predicting 100% chance for the Fed to hike by December (and occasionally, by September) the market is now looking at Fed action as less than certain. Whether they go or not, the dollar should continue to move higher. If they go, it will happen much faster, and have significant impact on emerging markets, US yields (paradoxically, pushing them down), growth, inflation and earnings.