Why investors are taking tighter monetary policy in their stride
A flurry of strong economic data amid expectations of Trump’s pro-growth policies has served to sustain investor confidence
Remember the “taper tantrum”?
This is the term that entered the financial lexicon on May 22, 2013, when the US Federal Reserve unexpectedly announced that it planned to wind down, or taper, its four and a half-year-old programme of quantitative easing, immediately triggering a disorderly sell-off in financial markets.
Fast forward nearly four years and the Fed-induced turmoil in markets feels like a distant memory.
The contrast between international investors’ distinctly positive reaction to the Fed’s decision on Wednesday to step up the pace of monetary tightening - the US central bank raised its benchmark interest rate by a further 25 basis points and signalled two further increases later this year - and the panic engendered by the winding down of quantitative easing could not be starker.
Between the end of April and early September 2013, the yield on benchmark 10-year US Treasury bonds surged nearly 130 basis points to just below 3 per cent, its highest level since mid-2011. The Vix Index, Wall Street’s so-called “fear gauge” which measures investor expectations of near-term volatility in US equity markets, shot up from 12.5 to 19 points – just below its long-term average - within a month after the Fed signalled its intention to start scaling back its asset purchases.
The most conspicuous deterioration in sentiment was in emerging markets (EM).
EM mutual bond funds suffered a staggering US$44 billion in outflows between the end of May and the end of November 2013, the highest level of sustained redemptions since EM emerged as a major asset class some 15 or so years ago, according to JPMorgan. Many EM currencies, moreover, suffered steep falls against the dollar, while the equity markets of Turkey and Indonesia – two members of the so-called “fragile five” group of vulnerable EMs which came to symbolise the dangerous over-reliance of many developing economies on large inflows of QE-driven foreign capital – lost 28 per cent and 19 per cent respectively between mid-May and late August 2013.
The reaction to the Fed’s current rate-rising cycle, however, is a different story altogether.
In the run-up to the Fed’s decision on Wednesday to raise rates – and particularly since the end of February when the odds of a rate increase this week suddenly shot up from 40 per cent to more than 90 per cent – equity markets were positively buoyant despite mounting speculation about a faster pace of monetary tightening.
The benchmark S&P 500 Index, which hit a fresh record high on March 1, has climbed 4.7 per cent since early February while the Vix Index, having surged to 22 just before the US presidential election in early November, has remained below 13 points since the end of last year.
More tellingly, the 10-year Treasury yield, while having risen 15 basis points since the end of February, is still 50 basis points below its post-taper tantrum peak of nearly 3 per cent in early January 2014.
On Wednesday, the 10-year yield even fell 10 basis points to 2.5 per cent as markets took comfort in the Fed’s decision not to tighten policy more aggressively.
The bullish sentiment towards developing economies is doubly striking in light of the Fed’s more hawkish stance.
The MSCI EM Index, a leading gauge of equities in developing nations, has shot up 9.4 per cent since the beginning of this year – and has even advanced slightly since the end of February when the probability of a March rate increase began to rise sharply. According to JPMorgan, EM equity and bond mutual funds have attracted more than US$13 billion of inflows this year, recouping all of the outflows suffered in the weeks following Donald Trump’s surprise victory in the US election.
So why are international investors taking the acceleration in the pace of monetary tightening in their stride?
The most important reason is the optimism generated by the flurry of stronger economic data in both developed and developing economies. Reflationary forces in the global economy are gaining momentum amid heightened expectations of pro-growth policies, including hefty tax cuts and deregulation, under the new Trump administration. This is mitigating the adverse effects of less accommodative monetary policy and, as I argued in my column earlier this week, fuelling perceptions that the stimulus baton is switching hands from central banks to governments.
Other factors are also at play. Sentiment towards China has improved markedly, monetary policy is still ultra-loose in Japan and Europe, and commodity markets have recovered.
Still, there are plenty of other potential tantrums on the horizon. Political risks in Europe are escalating while Trump’s ability to win Congressional approval for his economic policies is uncertain.
The Fed may prove to be the least of investors’ concerns.
Nicholas Spiro is a partner at Lauressa Advisory