The markets, both financial and commodity, have felt the chill winds of credit tightening several times in recent months, notably in May of 2013 and again in January of this year, causing a shock to emerging market indices and commodity prices as the markets began to contemplate the end of easy money. In reality money has stayed cheap on the back of Federal Reserve quantitative easing, even as the value of bond buying has gradually been cranked down, rates have remained benignly low.
A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, in this case bonds, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base.
We all knew QE wasn’t going to last forever and now it seems a robust US economy is going to force the Federal Reserve to raise interest rates next year. Exactly when next year remains to be seen, but the smart money is towards the end of the first quarter. The yield on 10-year US Treasuries – the benchmark price of global money – has already jumped 20 basis points to 2.54% since mid-August according to an article in the Telegraph over the weekend.
US growth reached 4.2% in the second quarter with the ISM manufacturing measure near a 30-year high. The paper is quoting Bank of America which expects yields to jump to 3.1% this year, and 3.75% by the end of 2015 as the Fed raises interest rates in earnest. Asset prices, and not just equities but gold and commodities, have been massively supported by easy money for the last five years. So, too, has the value of the US dollar been depressed, but as we have seen in recent weeks that is already beginning to turn. The exchange rate against the pound has been impacted by sterling weakness as investors finally wake up to the possibility Scotland may yet be mad enough to vote for independence from the UK, leading to a sharp sterling sell off. Yet, so too has the US dollar gained against the Euro and emerging market currencies with the exception of the Chinese Yuan which is in the early stages of something similar to the dollar.
China’s budget reform will soon halt rampant borrowing by local governments, adding fiscal tightening to the mix the Telegraph reports, as regulators seek to shut down chunks of the shadow banking industry. What will happen to loans as rates rise and credit is cut off is anyone’s guess.
Loans have risen from $9 trillion to $25 trillion since 2009, equal to the US and Japanese banking systems combined. Stephen Green, from Standard Chartered, is quoted as saying credit already exceeds 250% of GDP on all measures. Beijing appears willing to accept a slow down in GDP growth, the rate of which has long been the cornerstone of commodity prices, provided urban unemployment remains no more than 5%.
So far that is holding, suggesting further stimulus will be very limited and highly targeted. China injecting liquidity into the global system is also coming to an end, the central bank was still buying foreign assets at a pace of $40 billion a month in the first quarter, mostly US and EMU bonds. That has now ground to a halt.
The greatest risk comes from the level of cross-border dollar debt, the article suggests. Bank of International Settlements (BIS) data show that cross-border bank lending has reached $12.6 trillion, 63% in dollars. “Global dollar leverage has never been higher as a share of GDP with many emerging market companies – mostly in Asia – borrowing at rates as low as 1%. As rates rise next year debt repayment could double, or even triple from current levels.
Exactly how this will play out for emerging market firms, for emerging market economies and for dollar-based commodities remains to be seen but volatility looks like it could be back with a vengeance next year.