BackAvinash Persaud | The taper and the wall of money
The future direction of global markets has little to do with the reversal of a non-existent wall of money
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Despite the deft hand of Reserve Bank of India governor Raghuram Rajan, the rupee will come under renewed pressure later this year as international markets respond to the impending turn in the US interest rate cycle. The announcement in December by the US Federal Reserve that it was to moderate its bond-buying programme from $85 billion per month to $75 billion—otherwise known as quantitative easing, or QE,—was designed to provide the least disruption to financial markets and it appears to have succeeded.
Back in May, Fed’s attempt to de-sensitize the market to an eventual tapering triggered a far more dramatic, negative reaction to the rupee and other emerging market currencies. In response, Rajan and other central bankers requested the US take care of the way the tapering of QE was announced, and managed to effect change in US monetary policy as those concerns appear heeded. But this soft approach cannot hide the fact that the December announcement marks the next stage of the interest rate cycle, one that history suggests will be the final phase of the stock market rally, the beginning of bond market weakness and will spark renewed pressure on emerging market currencies.
Since the collapse of Lehman Brothers on 15 September 2008, Fed has been buying bonds from the public with electronically created cash in excess of $3 trillion. Its balance sheet has tripled. The balance sheets of the European Central Bank (ECB), Bank of Japan and Bank of England have increased by similar proportion, though the expansion occurred over a longer period in Japan, and ECB has preferred to issue long-term repurchase agreements to banks.
The first round of QE was a courageous, ad hoc, reactive affair, unpinned by theory and focused on unfreezing the financial markets. It was highly effective. Central banks bought a variety of unloved instruments, but with an emphasis on mortgage-backed and related paper, where the loss of confidence in their external credit ratings had created most paralysis. Measures of market stress that had been reaching for the sky in October 2008, turned sharply lower by March 2009.
Later rounds of QE were larger, better underpinned by portfolio balance theory, focused on long-dated bonds; and largely impotent. It could not have been any other way. The theory said that by giving long-term government bondholders cash instead, they would use this cash to buy long-term corporate bonds, pushing down yields and encouraging corporations to finance new investment. The measure of QE, then, is not how much government bond yields have been lowered but how much corporate investment activity has increased. Yet the very circumstances that bred a hunger for untraditional policies are the circumstances when the portfolio balance theory breaks down, when investors and corporates want to hold more cash and when there is little private sector appetite for new investment.
Far from wanting to invest their cash, banks and corporates have been hoarding it. Banks have unprecedented amounts of excess reserves and according to the Fed’s flow of funds accounts, non-financial corporate businesses held an unprecedented $1.79 trillion of aggregate liquid assets at the end of 2012. Despite the popular image, there has been no wall of money gobbling up assets at home and abroad. Cash balances have been trapped in a broken system.
Many commentators erroneously think that an asset’s price rises when there is a gush of cash buying it up, but the reality is that in response to good news, market-makers lift their prices until higher prices bring out sellers. Trading only takes place when there are disagreements over where the price should be. Asset prices have risen, but only as much as we should expect from rising future earnings being discounted to the present by a near-zero level of interest rates. Market makers have lifted their prices in response to these higher present values until they have found sellers. The rise of the stock markets in the countries with QE and elsewhere has been on unusually low volumes. QE has been an expensive distraction.
Near-zero interest rates in the US, the euro zone, Japan and the UK have been transmitted to strong-growing emerging markets, not through a wall of money, but through exchange rate arrangements. Where there were fixed exchange rates, policy rates were transmitted directly and where there were floating exchange rates, rates were transmitted via the struggle to keep emerging market currencies from appreciating over this period. Actual cross-border flows were no greater than before, though their source, and risk have shifted markedly from banks to asset managers.
The future direction of global markets has little to do with the reversal of a non-existent wall of money. QE has merely played the role of interest rate signal—albeit an expensive one—and its tapering will be seen as a signal that the rate cycle is turning. Looking back at the last eight interest rate cycles, this phase is strongly negative, and consistently so for government and high-grade bonds. In general, where there is economic expansion and low rates, housing markets and high-yield paper can still outperform and stocks can enter the final phase of their rally. The dollar will enter a cyclical upturn.
In India, the benefit of low interest rates elsewhere in the world was blunted by stubborn inflation and fiscal deficits, but the challenge of rising interest rates globally and a stronger dollar will not pass India by. Unless and until Indian corporate earnings rebound, the rupee and stock market will come under renewed downward pressure.
This article is based on a presentation given by the author at the annual CFA and Indian Association of Investment Professionals in Mumbai on 17 January.
Avinash Persaud is chairman of Elara Capital and an executive fellow of London Business School. He was formerly a senior executive at JPMorgan, UBS and hedge fund manager, GAM London.
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