11 December 2018

What would change the Fed’s tapering plan?

Hong Kong stocks plunged 2.89 percent on the first trading day of the new year, tracking losses in the S&P 500 in the United States. Lenovo Group Ltd. (00992.HK) was the worst hit, blowing more than 16 percent, the worst performer among blue chips.

Down 2.28 percent on Monday, the S&P 500 had its second worst close for any first trading day in February since 1928.

Several factors were at play in these declines, not least the US Federal Reserve’s decision to wind back its asset-buying program.    

The HKEJ’s investor diary looks at how the Fed tapering might play out.

Global stock markets have turned upside down over the past month or so. Bonds and gold have decoupled from stocks, fueling speculation of a collapse in emerging markets reminiscent of 1997.

The governor of the Reserve Bank of India has criticised the US central bank for negligence in handling the impact of its tapering on the currencies of emerging markets.

Richard Fisher, chairman of the Federal Reserve Bank of Dallas, returned fire, saying the Fed makes its policy in the best interest of the country and implying that emerging economies should not expect the US to postpone its fund withdrawal plan unless the current turmoil in emerging markets directly threatens the world’s largest economy.

Speaking of the 1997 slump in emerging markets, investors may recall that the Fed fund rate was indeed urgently cut three times in a row but not in that same year.

The US did not take action until 1998 when Long-Term Capital Management LP (LTCM), the US hedge fund that had bet heavily on Russian bonds, got burned as the ruble exchange rate collapsed after the country defaulted on its bonds, a spillover from the Asian financial crisis.

The Fed negotiated with Wall Street investment banks on how to save LTCM on one hand and cut the Fed fund rate on the other to ease the negative impact on the US economy.

This nugget of financial history tells us that only when a regional crisis in emerging markets hits the US will the Fed take action. Otherwise, it will remain hands off, observing the situation as happened in the early days of the Asian financial crisis.

With that in mind, it is unlikely the Fed will change its tapering policy this time either — unless the US economy deteriorates drastically.

Only Mexico and China are important enough to hurt the US economy if they become embroiled in the problems of other emerging markets. Mexico accounts for 14.4 percent of US exports and China 7.5 percent.

Despite the fact that a majority of players in the eurodollar futures market are betting on a faster economic recovery in the US that could send Treasury yields above 3 or even 4 percent, disappointing US employment numbers and equally weak manufacturing data from the Institute of Supply Management for January have dragged the long-term yield down to 2.6 percent from more than 3 percent at the end of last year.

The underlying causes of these key statistics hold the key to the next monetary policy move by Fed chief Janet Yellen.

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Freelance journalist

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