23rd June 2013
Asset prices and volatilities across the world surged in the past week (ending Friday, 21st June) after FED comments that it would consider ‘gradually’ tapering its massive $85bn a month bond buying program by the end of the current year (most likely in Dec) or beginning of the next year. Bonds and stocks plummeted globally and dollar appreciated against all major currencies.
The common reason provided for the correction in asset prices is mainly
As the FED intervention at the long end of the yield curve recedes, bond yields (long term interest rates) should rise sharply
Rising rates are bad for the economy as it would impede borrowing (mainly recovery in housing through higher mortgages rates) and consumption
Lesser liquidity would translate into reduced demand for other risk assets
Additionally, the above reasoning and sudden change in sentiment spurred capital outflow from EMs bonds and equities resulting into sharp depreciation in asset values and currencies of many EMs.
We find the above reasoning and its subsequent implications as they have unfolded over the past week to be surprising rather close to surreal. Our reasoning is as below
The QE was a emergency measure and was expected to be withdrawn at some point, its colloquial to an individual on a life support who has subsequently recuperated enough to get off the life support, this would be regarded as an incrementally good news. However, the market action past week was as if, the news was incrementally negative
Secondly, The argument with interest rate going up and the economy being stifled at the same time is one that is internally inconsistent. The Fed intends to roll-up the printing press only when it is satisfied that the economy is on path of sustainable recovery and has categorically stated that as a precondition to determine the timing and extent of the tapering. If the incoming data on the health of the economy were to be weak, long term rates will remain muted irrespective of the monetary exercise continuing or not.
For one, US economy has plenty of spare capacity as reflected in its current and targeted unemployment rate. Secondly, stronger dollar would pull down any tendencies in imported inflation, both developments keeping domestic inflation in control. Fundamentally, long term rates have been guided by two major forces 1) expected inflation and 2) growth prospects, with many economist now penciling the trend GDP growth rate at 1.5% and current inflation expectations at 1.5% long term rates (currently at 2.5%) have limited room past 3.5-4.0% in the medium term (c.2015). Thirdly, improvement in fiscal and current account deficit (stronger dollar; shale gas; and fiscal sequestration) should reduce run rate of Treasury issuances this and next year. It is also pertinent to note that T-Bond demand from overseas Central Banks is irrespective of the yield and will likely remain strong.
We also tend not to agree with the argument that rising rates will suffocate the benign recovery in housing through higher mortgage rates. It needs to be noted, that the recovery in US housing is broadly location and sector specific. Housing market in US has structurally changed between now and 2008 in terms of both financing access and demand. And is coming out after way-warding at the bottom for three straight years! As long as the expected return on the asset is above its costs, high interest rates in itself are not sufficient to stifle demand.
Lastly, the fear that lesser liquidity will be bad for risk assets is logical deduction but may not be factual in the current situation. Globally, prices of commodities, precious metals, equities (mainly EMs) are down YTD and many parts of the world are seeing correction in real estate prices. The general mood among market participants is more of gloom and towards safety than optimism and adventure. Asset bubbles are more likely to arise in the later state than former. The only asset class that we believe should logically be pricked by rising in interest rates is credit spreads trades such as Corporate and Junk bonds, USD denominated non-US Sovereign debt and TIPS where credit spreads were it lowest and may expand in coming days as the attractiveness to take advantage of higher yields available with T-Bonds adjusted for expected inflation surpasses the risky credit bet in credit spread products.