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QE was a emergency measure and was expected to be withdrawn at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.
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