By Maitse Motsoane, Portfolio Manager at Prescient Investment Management.
Re-pricing of risk has proved to be a theme for 2018 as central banks gradually reverse conditions that underpinned the risk-seeking behaviour of the last decade. Cracks in the system became apparent in the US funding market in January with the widening of Libor-OIS spreads. This was followed by a volatility spike in February, that catalysed a sharp equity market sell-off and the complete meltdown of popular strategies that bet on low volatility. While these events might appear to bear little significance in the broader scheme of things, we believe they embody symptoms of less accommodative global financial conditions – which underscored the US Dollar’s resurgence in the second quarter of the year.
In hindsight, the widely held negative view on US Dollar during the first quarter of the year suggests there was an under-appreciation of the tightening of global financial conditions – precipitated by Fed’s balance sheet reduction at a time when policy rates have been creeping higher. To add a little perspective, the multi-year balance sheet shrinkage process that began in October 2017 will see total reduction for 2018 amount to around $300bn (or 15% of total shrinkage) if the Fed aims to cut back the size to $2.5trn (from $4.5trn). Admittedly, the optimal size of the Fed’s balance sheet may very well be higher than the $2.5trn indicated above, as changes in regulation has increased the demand for bank reserves. Meanwhile, the fed funds rate has been lifted by 125bps since the beginning of 2017. Indeed, this represents somewhat of a structural shift back to normality as the cheap money that fuelled animal spirits and the global search for yield during QE years dries up.
The unconventional monetary policy prescribed by policymakers to mitigate the risk of deflation in the aftermath of the 2007/2008 global financial crisis appears to have had a much more pronounced impact on financial asset prices as opposed to prices of goods and services. Central banks created money to finance the large-scale asset purchase programmes that were designed to curb long-term interest rates when short rates hit the zero-bound. This resulted in suppressed levels of asset price volatility as the system became awash with low-cost US Dollars, which in turn supported the risk-on sentiment that drove demand for risky assets such as emerging markets stocks and bonds.
But what does QE exit mean for broader global markets? Well, the answer lies in unpacking the distortions that years of QE has had on financial markets (low volatility, suppressed term-premium etc), and analysing the possible effects of a return to normality. For starters, since the crisis, term premium has explained large moves in the 10-year treasury well (with US yield curve exhibiting a tendency of bear-steepening and bull-flattening).
However, this could be a thing of the past. As such, the current increase in the 10-year bond yield has been led by the front-end of the curve, which signifies a breakdown in the regime of the past decade. The divergence between the 10-year yield and term-premium seen in the chart below highlights the insignificance of term-premium (as estimated by the Fed’s ACM model) in explaining the rise in US 10-year yield over the past 2 years. However, this is consistent with pre-QE tightening cycles. Inflation-targeting central banks adjust policy according their mandate and reading of economic conditions. Therefore, in a tightening cycle, yields on long-term bonds do not rise as much as short rates due to contained long-run inflation expectations – resulting in a flatter yield curve.
Consequently, the spread between 2- and 10-year US bonds has narrowed markedly (Current: 0.25% vs Dec 2015: 1.25%) since the Fed delivered the first post-crisis policy rate hike in December 2015. With the FOMC’s dotplots projecting two more hikes in 2018 and several more next year, it begs the question of whether Fed will continue raising rates even if it means inverting the yield curve. It is of concern for market participants as inversion of the US yield curve has proved to be an impressive indicator of imminent recession.
Additionally, easy monetary conditions in key currency countries have propagated themselves to the rest of the world – to emerging markets and small advanced economies alike. Past experiences show that emerging markets often find the lure of cheap US Dollar financing irresistible during periods of prolonged ultra-accommodative policy, thus causing a build-up of vulnerabilities to a sharp reversals of capital flows. And when the tide does eventually turn, rising volatility spurs flight to safety that engenders a rapid unwind of the carry trade. This leads to the kind of USD strength (or other low yielding hard currencies used to fund carry trades) that characterized the second quarter of 2018 – making it harder for emerging market countries with large USD borrowings to service debt with assets that generate local currency.
External vulnerabilities in Turkey have kept financial market participants on their toes over the past couple of months. Even though tremors felt in the Turkish economy might appear somewhat isolated from a trade and financial linkages point of view. Currencies from other countries that display similar vulnerabilities (wide external trade deficits, asset/liability mismatches, macro policy vacuum) such as the Argentinian Peso and South African Rand fell under pressure as risk-off trading took centre stage. The Reserve Bank of India governor, Urijt Patel, sounded the warning bells in his article published by the Financial Times in June. He outlined how the Fed’s balance sheet unwind, coupled with increased supply of treasuries (due to tax cuts) will drain dollar liquidity. This will present significant headwinds for the rest of the dollar bond markets and carries the possibility of plunging some of them into crisis.
While the need for policy normalisation is understandable given that economic recovery in the US has materialised, due care must be exercised by the FOMC members when assessing the spill-over effects of their decisions on the broader global financial system. In the Committee’s June summary of Economic Projections, estimates of the real neutral rate ranged from 0.25% to 1.5%. With effective fed funds rate currently trading at 1.9%, and core PCE (the Fed’s preferred measure of inflation) at 1.9%, it means that real fed funds rate is close to zero. So, despite the wide range of neutral rate estimates, policymakers can unanimously agree that current policy stance is still accommodative. But with two more hikes likely to be delivered this year, the committee might find it difficult reaching an agreement on appropriate policy actions going forward. This presents a degree of uncertainty in policy outlook for 2019. As we enter a period of a lot of unknowns and what-ifs, forward-guidance and policy predictability will absolutely be crucial for maintaining financial market stability and manageable levels of volatility.
Implications for SA
SA has relatively small USD denominated debt compared to countries such as Turkey and Argentina. Therefore, asset/liability mismatches on the back of Dollar strength do not pose a key risk locally. However, non-residents own about 40% of SA’s government issued debt. The chart below illustrates how portfolio flows into SA have increased on the back of dwindling foreign direct investment since 2012. From this, we can infer that SA has increasingly become reliant on “hot money” to finance it twin deficits. And, with a rise in global risk aversion, the deficits will become increasingly harder to finance.
This, in turn, will translate into higher borrowing costs for the government as persistent selling by non-residents pushes bond market yields higher. Increasing borrowing costs may undermine the fiscal consolidation path outlined in the February Budget statement, and could re-introduce sovereign downgrade jitters going into Moody’s SA rating review in October. Furthermore, sustained weakness in the Rand might start feeding through to second round effects on inflation as retailers pass on higher import costs to consumers – a point at which the SARB’s MPC might hike the policy rate to contain price growth. Moreover, SA’s external vulnerabilities (as measured by current account plus budget balance as a percentage of GDP) are high relative to other countries in its emerging market peer group. And with several of these countries’ central banks having delivered policy rate hikes over the past couple of months, the SARB’s monetary policy committee will need to maintain elevated real yields to attract foreign capital flows – reducing the likelihood of a rate cut in the process.
Undeniably, the implications of tighter global financial conditions highlighted above are by no means exhaustive. We are in times of elevated uncertainty, and higher asset price volatility should be the name of the game in the foreseeable future.