When easing gets difficult

When easing gets difficult

Ten days after the US Federal Reserve announced it would embark upon a programme of quantitative easing, markets haven’t exactly been behaving as predicted. The logic of the easing was simple enough—the Fed would buy bonds thereby increasing bond prices and lowering yields. The hope was that the lower yields would induce consumers and businesses to borrow and invest. It was also expected that very low interest rates would lead to a search for yield and that would mean funds flowing out to risk assets.

But consider the yield on the benchmark 10-year US treasury note. This fell from around 2.7% in mid-September to 2.4% or thereabouts in early October. This was accompanied by large flows to equities, and markets— especially emerging markets— moved up smartly on the back of these flows. Funds also poured into commodities.

More recently, however, these indicators have turned. For instance, the yield on the US 10-year treasury note reached a two-month high on Monday. And this has happened despite the US Fed announcing its first tranche of bond buying. The question is: If US bond yields do not fall, will it not lead to less funds flowing out to emerging markets? That is precisely what has happened in recent days, with sudden drops in the MSCI Asia ex-Japan index, the US dollar index and the CRB Reuters/Jefferies index that tracks commodities.

There could be several reasons for the pause. The most obvious one is that the markets had already run up quite a bit before the announcement and asset prices do not go up in a straight line. There are also worries about renewed problems in Europe’s periphery. But perhaps the biggest concern lies in the rise in Chinese inflation and fears that the Chinese central bank will have to hike interest rates to cool the economy.

The fact that world markets are worrying about an increase in Chinese interest rates is a telling indicator of the shift of economic power to the East.

It is also a warning that the inflationary consequences of loose monetary policy in the West will be borne by emerging markets. It is very likely that what we’re seeing at the moment is a pause and that the Fed’s determination to keep interest rates as low as possible for as long as it takes to revive the US economy will see continued large flows to emerging markets. Japan’s experiment with quantitative easing, for instance, spawned a large carry trade. But the uncertainties are huge and the reaction of the monetary authorities in the emerging countries will have to be taken into account. That is likely to keep markets very choppy.

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