Three reasons not to fear a dollar-driven financial crisis in emerging markets
The strong dollar has emerged as the new ‘fear gauge’, and its pointing to increasing funding pressures in emerging markets
When it comes to the erratic conduct of US monetary policy, financial markets are rarely certain about the outcome of the Federal Reserve’s monthly interest rate-setting meetings.
Yet when the Fed meets next week, bond investors are attaching a 100 per cent probability to a 25 basis point rise in rates, which would be the second increase since the US central bank’s momentous decision last December to tighten monetary policy for the first time in nearly a decade.
The crucial question, as far as markets are concerned, is not whether the Fed hikes rates on December 14, but whether it signals a faster pace of rate increases next year in anticipation of a sharper-than-expected rise in inflation stemming from US president-elect Donald Trump’s plans for a hefty debt-fuelled fiscal stimulus package.
The Fed’s decision, and the accompanying press conference by Chair Janet Yellen, has significant implications for the dollar, which has already risen sharply since Trump’s upset victory. On November 23, the dollar index - a gauge of the performance of the greenback against a basket of its peers - surged to its highest level in 13 years.
While it has since fallen, the index remains above the psychologically important level of 100 and is up more than 6 per cent since mid-August, with half the increase occurring since early November.
The global financial implications of a renewed and sustained rise in the dollar, the world’s most actively traded currency, are so profound that the Bank for International Settlements (BIS), the so-called central bankers’ bank, claims the greenback is replacing the Vix Index (a closely watched indicator of stock market stress based on the implied volatility of the benchmark S&P 500 index) as the main “fear gauge” in markets.
According to a working paper published by the BIS on November 11, the rise in the dollar is increasing the costs for banks to hedge currency risks, endangering cross-border lending in dollars and increasing funding pressures in emerging markets which have witnessed a rapid build-up in dollar-denominated corporate debt since the 2008 global financial crisis.
“The dollar is a global risk factor, which affects the risk-taking capacity of banks and, ultimately, the supply of cross-border bank lending,” the BIS paper notes.
Hyun Song Shin, the BIS’s head of research, was more outspoken in a speech in London on November 15 when he said “the dollar has supplanted the Vix Index as the variable most associated with the appetite for leverage. When the dollar is strong risk appetite is weak.”
Last month, the economies of emerging Asia suffered what some analysts believe is a foretaste of things to come.
According to Bloomberg, US$15 billion gushed out of Asian bond and equity funds last month - a staggering 30 per cent of the total inflows this year - partly as a result of the post-election surge in the dollar which has increased the cost of servicing dollar debts.
The capital outflows are fuelling concerns about a dollar funding squeeze in emerging markets, exacerbated by de-globalisation in money markets and, according to Deutsche Bank, the repatriation of US corporate earnings held in Asian markets if Trump fulfils his campaign promise to overhaul the US tax code.
Still, a full-blown dollar-driven financial crisis in emerging markets is unlikely.
For starters, outflows from emerging market bond and equity funds following Trump’s victory were already abating by the middle of last week. According to JP Morgan,emerging market equity funds even enjoyed net inflows of just over US$100 million in the week ending November 30, compared with a massive US$6.2 billion in outflows in the week ending November 16.
Secondly, the scope for a further rise in the dollar hinges crucially on whether the so-called “Trumpflation” trade - a repositioning of investors’ portfolios in anticipation of sharper hikes in US interest rates to combat a debt-fuelled surge in inflation - gains traction in the coming weeks and months. For the time being, the jury is still out on how successful Trump will be in implementing his reflationary economic policies.
Thirdly, underlying demand for higher yielding emerging market assets remains strong given the huge stock of negative-yielding government bonds. While last month’s bond market sell-off has reduced the amount of European and Japanese debt with sub-zero yields, the value of negative-yielding bonds still stands at nearly US$11 trillion, according to new data from the Financial Times.
Yet when the Fed hikes rates next week - a near certainty - the markets’ new “fear gauge” will doubtless be ringing alarm bells.
Nicholas Spiro is a partner at Lauressa Advisory