June 12, 2013 4:13 pm
Markets Insight: Central bank loss of control leads to EM tumble
By Ralph Atkins in London
Tear gas and riot police fill Istanbul’s Taksim Square. Investors fret about the growth outlook in India and China. But these were not the main factors behind sharp falls this week in emerging economies’ bond prices, and corresponding rises in yields.
Instead, the story was about how the world’s central banks lost control, at least temporarily, over market interest rates, heightening fears about disruptive times in prospect as they head for the eventual withdrawal of their exceptional support for economies.
While it is not clear that we are at the beginning of a great global bond market sell-off, we have at least learnt a little more about how successive waves of monetary policy loosening might work in reverse. It has not looked pleasant.
Over the past few years central banks, led by the US Federal Reserve, have encouraged “portfolio rebalancing” across financial markets. Tumbling yields on US Treasuries persuaded investors to shift into something riskier. Those already in riskier assets took bigger risks – maybe in emerging market debt. It was like the nursery rhyme Ten in a Bed in which “the little one said: ‘Roll over, roll over’” ... And as any child knows, “ ... they all rolled over, and one fell out”.
The yield on bonds in JPMorgan’s emerging market EMBI diversified index has risen more than a percentage point to 5.5 per cent during the past month. Fears about economic as well as political weaknesses put Turkey among the worst performers. With activity hectic, traders on some fixed income desks have reported record flows in the past few days – suggesting forced selling (or perhaps opportunistic buyers?). Volatility has spread to equity markets, with the FTSE All-World Index down 4 per cent from its May peak.
Behind the falling-out-of-bed were signs that global quantitative easing was entering an uncertain phase that will undermine lucrative carry trades – borrowing in a low interest rate currency to invest in higher yielding assets.
On one view, the initial cause was volatility in Japanese bond markets; the Bank of Japan has struggled to guide yields since launching aggressive bond buying plans to drag the economy out of deflation. The sell-off really gained momentum, however, after Ben Bernanke, Fed chairman, hinted on May 22 at a possible “tapering” of US quantitative easing. His comments shifted expectations from a bias towards “no change, possible further loosening” in QE to talk of possible tightening. It was a subtle change – but the effects were striking.
Ten-year US Treasury yields have risen 60 basis points since the start of May, and markets are pricing in a Fed hike as early as January 2015 – at least six months sooner tan economists’ consensus view. Disruption has spread into credit markets and globally.
German 10-year Bund yields have jumped from 1.15 per cent to 1.61 per cent – the sort of jump seen during the most intense phases of the eurozone debt crisis. While the eurozone remains deep in recession, interest rates on three-month euro loans starting in December 2014 have risen from 0.48 per cent to 0.64 per cent during the past week – one of the sharpest five- day jumps this year.
As ever, movements were almost certainly exaggerated as some investors found themselves wrongfooted; the most egregious example were trend-following hedge funds, which took big losses. The lesson, however, is that turning points in the interest rate cycle are messy.
Central banks are not about to raise the white flag of surrender. Global quantitative easing measures remain firmly in place – the Fed has an opportunity at its meeting next week to reset market expectations about any scaling back - so some investors will see a chance to buy.
Then there is the role of the Bank of Japan. Markets initially assumed the central bank’s aggressive action would drive Japanese investors into riskier overseas assets, with positive “roll over” effects for emerging markets.
It did not work out like that. Instead a weaker yen encouraged Japanese investors to reap windfall profits by selling overseas holdings. Now market volatility has reduced risk appetites, while higher yields in US and European bond markets have further reduced the relative attraction of emerging market debt. Calculations by HSBC show that after hedging back into yen, yields on many emerging market bonds are less attractive than investing in Japanese government debt.
Still, like the Fed, the Bank of Japan has time to change tactics, perhaps by accelerating its bond buying. With bond markets stabilising on Wednesday, the sell-off does not yet seem to be a rout. A bout of calm could restore confidence in emerging markets.