Since its first hike in December 2015 the Federal Reserve has delivered a 225bps hiking cycle. Over the same period the main Central Banks in Emerging Markets have hiked only 50bps on average, or they actually cut policy rate by -33bps when removing Turkey. We could infer from these numbers that EM CB don’t really include the Fed policy in their reaction function – or in other words that they exhibit a low beta to the Fed policy rates. We think that this would be incorrect and here is why.
First, the above period of reference is misleading. The real turning point in the Fed tightening cycle is better captured by Taper Tantrum (May-June 2013) than by the first Fed hike (December 2015). The sharp rise in US real yield which occurred in the second half of 2013 led to tighter financial conditions across the board especially for at the time the so-called “fragile five” economies –Turkey, Brazil, South Africa, India, Indonesia – which shared the common feature of being particularly externally exposed. Between Taper Tantrum and the first Fed hike (December 2015) the Central Banks in the fragile five countries hiked between 75bps (Reserve Bank of India) and 675 bps (Bank Central of Brazil) in an effort to protect their currencies.
Second, disinflation in emerging markets has been an offset to the Fed hiking rates. With the exception of some idiosyncratic crises which led to currency depreciation and an inflation spike – such as in Turkey in the summer of 2019 or in Russia in 2015 – inflation has been moderating across most regions. Latin America and Asia overall have seen a very clear downward trend in YOY inflation prints driven by core and non core items. Central and Eastern Europe has been an exception to the rest of EM as the only region which has seen higher core inflation pressure fuelled by tight labour markets and strong wage growth. Emerging markets have been able to maintain elevated real yields relative to developed market not by hiking aggressively but by better anchoring inflation.
Third, looking at the average across the whole period masks a succession of three distinct regimes. The first period started from the Taper Tantrum and continued until 2016. In this period EM Central Banks had to adapt to the switch in the Fed stance and the more externally vulnerable countries were forced into hiking as mentioned above. During the second period – from 2016 to 2017 – the Fed hiked in a well telegraphed manner which did not destabilize the emerging market complex. Central Banks in a number of Emerging Markets were able to engage in deep cutting cycles for example Banrep (Colombia), BCB (Brazil) or NBR (Russia).The third period (2018) saw a resumption of hikes which were driven by a mix of better growth and the necessity for some EM Central Banks to compete with Libor in the 2-2.5% context. In 2018, we saw a number Central Banks hiking rates across the whole low yield-high yield spectrum and in particular Banxico (Mexico), BI (Indonesia), SARB (South Africa), CBRT (Turkey), BCCh (Chile) and CNB (Czech Republic).
Fourth, the sensitivity of EM Central Banks to the Fed varies highly across countries. Banxico stands out as one of the most sensitive Central Banks to the Fed policy as it targets a yield pick up over the Fed rates to compensate for political risk and attract investors. It hiked 425bps since Taper Tantrum. In general the most externally dependent tends to be more exposed to the Fed policy rate (CBRT, BI, RBI, SARB, Banrep) while the Central European Central Banks are less exposed to the Fed as the ECB dominates as a reference point. Mid yielder Central Banks – think BCR (Peru), BOT (Thailand), BNM (Malaysia)- fall somewhere in the middle.
In sum, EM Central Banks have in fact a relatively high beta to Fed policy rates. Going forward we therefore believe that EM Central Banks will deliver a significant cutting cycle across most countries and that they will at least match the Fed cutting cycle, which implies a beta of one or potentially even higher. In a number of countries, real policy rates have increased considerably over the last 5 years and there is room for cutting as activity is slowing down. In the last 13 weeks, 53% of the EM Central Banks have already delivered cuts. After the Fed cut we expect that close to 75% will have joined the party.
This is not a forecast. This is not a bold prediction. This is not something that we hope happens. This is an observation of what is unfolding in the markets right in front of us. The 10 year Treasury peaked at 3.25% on November 7, 2018 and has fallen relentlessly to 1.93% on July 3, 2019. Today, 32% of the global government bond market and 24% of the global aggregate bond market have negative yields. We should consider it a warning that this is the path the market is on unless there is an adequate policy response.
What is surprising is that the dramatic decline in yields has happened against a backdrop which would have suggested otherwise. The last move by the Federal Reserve was to raise interest rates on December 19, 2018. The Fed is also in the process of running down its balance sheet by up to $35B per month. Assets in US money market funds have increased steadily over the last 9 months to nearly $3.3T, the highest level since the Great Financial Crisis when the Fed provided an unlimited guarantee to these funds. Equities, gold and crypto currencies have all risen to recent cycle highs. Further, the US economy could be characterized as ‘OK’. So, what is driving the flows into US government bonds, and where is the money coming from? More importantly, if all of these factors turn, where do yields go from current levels?
Quite simply, the money is pouring into the US bond market from overseas. As the volume of negative yielding debt grows across Europe and Japan, investors are seeking a safe haven that has a positive yield. US investors have neither embraced the decline nor pushed back on it. As trade tensions escalate, the probability of recession rises. There is also the very real risk that inflation expectations have become unanchored and central banks are gradually becoming powerless. New York Federal Reserve President John Williams, in his July 18 remarks to the Central Bank Research Association, brilliantly articulated this risk by saying that “investors are increasingly viewing these low inflation readings not as an aberration, but rather a new normal”.
While there has already been a dramatic decline in US yields, an accelerated move lower is potentially in the offing. If, as expected, the Federal Reserve begins a rate cutting cycle at the end of this month, money will be shaken out of money market funds into bond funds in an effort to lock up a higher yield. That is a vast pool of money that could come into US bonds. A second large pool would come from a return to central bank balance sheet expansion. The Fed is expected to end its balance sheet run off in September just as the European Central Bank returns to Quantitative Ease. A third pool of money could come from de-risking. The escalation in tariffs has surely raised the probability of recession. From current levels, the combination of central bank action and de-risking would accelerate the journey of US bond yields toward zero. This is not healthy for savers who rely on a fixed income or for insurance companies and pension funds that have discounted liabilities to meet.
There needs to be a policy response that is swift and dramatic enough to stop this descent in its tracks and reignite growth and inflation expectations. A starting point is with the central banks and the Federal Reserve in particular. They must respond at month end with ‘shock and awe’ to regain control. A mere 25 basis points insurance cut by the Fed will be dismissed by the markets, and investors will pile into intermediate and long duration bonds. Whether they cut by 25 bps or 50 bps, the Fed must make it clear that they mean business and will do whatever it takes from that point onward to raise inflation expectations. The European Central Bank must also respond. ECB President Mario Draghi should lay out the path for rate cuts further into negative territory and a return to Quantitative Ease before he hands over the reins to incoming president Lagarde.
While the central bank policy response is likely to happen, it is important to remember that monetary accommodation alone is not enough to avoid recession this late in an economic expansion. Otherwise, we would never have recessions. Will it buy enough time for a policy response to happen elsewhere? While there could be a de-escalation in tariffs, the direction of travel in the last 18 months has been consistently opposite. It would also be nice to see some co-ordinated fiscal stimulus. But which government has the courage and ability to embark on a deficit spending program?
The central banks must take the lead, and it must start this month. They must bring front end real yields so low, so fast that the yield curve steepens. That will cause investors to question the wisdom of holding longer maturity bonds in the face of coordinated central banking so committed to reflation. Anything short of that risks the 10year US Treasury remaining on the well-worn path, forged by Japan and Germany, toward zero.