Who should worry about the U.S. normalizing interest rates?

Global financial markets are adjusting again to the expectation of normalization of U.S. interest rates. The first leg down followed the Fed’s signal for decreasing quantitative easing in June and eased after the Fed talked down its tightening bias. The second leg has begun with recent strong employment statistics for the United States. The magnitude of the adjustment reflects in the rise of the U.S. treasury yield. It rose by about 100 basis points in the first round. The second round could be similar in size.

Emerging markets are most affected by the adjustment. They experience triple whammies in currency declines, interest rates rising and credit spreads expanding. Some emerging markets were shaken hard in the first round. The risk of one or more tumbling over is still significant. Brazil and India are the risk spots among major economies.

Commodity currencies may resume declining. The Australian dollar, Canadian dollar and Brazilian real are risky assets. One difference in the second round is a flattish U.S. dollar. The surge in the U.S. dollar during the first round proved premature. As the interest rate adjusts slowly due to the Fed holding it down through its signaling and QE purchases, the money in emerging markets is not rushing back into the United States. The U.S. dollar may resume its strengthening path when the market believes that the treasury yields have stabilized.

Gold surprises with its strength. The surge in emerging market demand has spooked short sellers. As demand from emerging economies rise above the annual production, gold pricing will shift from the West to the East. Gold prices in future may follow China’s money supply rather than that of the United States.

The current round of adjustment will likely end when the Fed announces the speed of its QE is tapering. The odds are that it would be between US$ 5 billion and US$ 10 billion per month. If it is the lower end, the risk assets would rally and vice versa. Of course, if another emerging market crisis breaks out, the Fed will likely postpone its tapering.

The Second Leg Down
U.S. treasuries are falling again. The market is advancing its expectation of the Fed unwinding its QE program or the so-called tapering. The catalyst appears to be recent strong labor data. After the Fed signaled tapering in June, the 10-year treasury yield surged by 1 percentage point. Risky assets around the world tumbled. Fed officials quickly came out to calm the market by tuning down the expectation for the speed of its tapering.

I believe that the United States is experiencing a financial bubble again. The Fed’s QE program has artificially held down the bond yield. The U.S. economy is growing at 4 percent to 5 percent in nominal terms. The 10-year treasury yield should be similar to that. By holding it down to as low as 1.5 percent, it has encouraged speculation with debt financing. This is why the United States’ household net wealth has surpassed the height during the bubble years by a wide margin. No changes in economic fundamentals could justify such rapid increase in wealth.

The bubble wealth effect is adding momentum to the U.S. economy. Without fiscal consolidation, the U.S. economy could be growing twice as fast now. Fiscal contraction is holding back the growth rate. This is why the bubble alarm bell has not sounded. Hence, the speculative momentum in the market was accelerating before the Fed began to talk about tapering. The Fed, I believe, is trying to slow the bubble. Otherwise, it would be like 1999-2000; the market would surge in the second half of 2013 and crash in the first half of 2014.

Trying to control a bubble is risky business. A bubble either inflates or deflates. After the Fed began to talk about tapering, the market fell sharply. The bubble could be over right there. The Fed came out to bail it out by sounding dovish again, which caused the U.S. dollar to fall back and the U.S. stock market to stabilize at a high level. The message from the Fed is clearly that it wants the market to stay up. When everyone realizes this, there will be a stampede into the market. My bet is that the market would rise substantially before the end of the year and fall badly in 2014.

The Eye of the Storm

The Fed’s tapering expectation is hitting emerging markets hardest. Since 2008, trillions of dollars of hot money have flooded into emerging markets, triggering rapid credit growth and asset inflation there. Their economies all turned bubbly. The market then saw economic strength as a sign of emerging markets decoupling from developed ones, hence, justifying the optimism associated with hot money. The BRIC concept became hot in the market. It was the symbol for this emerging market bubble, possibly the biggest in history.

Brazil and India are front and center in the storm of hot money reversal. Their currencies tumbled one-fifth soon after the Fed indicated the tapering possibility. They are so vulnerable because they have large current account deficits. When hot money leaves, they need to close their current account deficits quickly. A big devaluation is the only way. But, this increases inflation and requires interest rates to rise. After many years of rapid credit growth, surging interest rates could trigger a debt crisis. If the interest rates are not increased, inflation and devaluation may go into a death spiral. A crisis will ensue anyway.

Indonesia is in trouble too. Even though its current account deficit is recent, and its domestic debt level low, foreign money is heavily into its government bonds, owning about one-third. As foreign money is pulled out, local interest rates rise, and stocks fall. But Indonesia is in a much better shape than either India or Brazil. It has learned from the crisis 15 years ago. It does not have much foreign debt. The local indebtedness is among the lowest in the world.

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