Worries about the US Federal Reserve tapering its bond purchase programme as a consequence of an economic recovery in the US have led to a sell-off in risk assets.
The MSCI equity indices show that dollar returns from the MSCI US index have been a negative 0.27% this month, minus 0.48% in Japan and minus 0.45% for MSCI Europe. Emerging markets have borne the brunt of the selling, with MSCI EM down 5.47%. MSCI India has had a negative return of 5.06% so far this month.
Interestingly, the situation is very different if we consider returns in local currencies. MSCI India is down 3.26% in local currency terms, MSCI Europe is down 3.62%, while MSCI Japan is lower by 6.78%. The difference is that emerging market currencies such as the Indian rupee, the Brazilian real and the South African rand have depreciated against the US dollar, but the yen and the euro have appreciated.
Indeed, if we take the US dollar index, which measures the performance of the dollar against a basket of developed world currencies—the euro, yen, British pound, Swiss franc, Canadian dollar and the Swedish krona—we find a remarkable coincidence. The dollar index reached a peak of 84.422 on 22 May, the day Fed chairman Ben Bernanke made his market-shaking remarks about the Fed tapering its bond buying programme.
One would normally have expected that to have been a signal for the dollar index to strengthen, but that hasn’t happened and it’s now at 80.67. Many reasons have been adduced for this, including market disappointment with Prime Minister Shinzo Abe’s restructuring plan for the Japanese economy, a return to safe havens by Japanese investors and a feeling of being let down by the European Central Bank chief not promising to ease further. But it could just be an unwinding of the rally in the dollar since February 2013. The impact has been good for the US—an improvement in competitiveness of US firms vis-à-vis competitors in Europe and Japan and also competitive gains for US firms with manufacturing operations in emerging markets.
Emerging market bonds, too, have been pummelled and credit default swap prices have risen sharply. Higher bond yields in the US have led to carry trades being unwound, putting pressure on risk assets. But the problem for the Fed is that the higher US bond yields, including higher mortgage rates, will hurt the weak recovery in that country.
That is why Bernanke will need to ensure that the message coming out of the federal open markets committee meeting on Tuesday and Wednesday assuages market fears about Fed tightening. Much depends on the wording. If it merely states that the Fed’s course of action will be data-dependent, it could mean continuing volatility and probably a continuation of recent trends. The markets will be calmed only if they are reassured they will not be deprived of their regular liquidity injections anytime soon.