The Creeping Fear Of The "Great Normalization" Of US Monetary Policy
There is a recurring nightmare that is playing out once again in many of the most leveraged asset-classes in the world's so-called 'markets'. The theme is that of an improving US economy which is pointing a normalization of US monetary policy. Good news, right? It would seem not; as Chris Wood's Greed and Fear notes, that the practical reality is that the emerging world, including Asia, will remain vulnerable to further selling so long as markets are anticipating normalisation of American monetary policy and a related strengthening in the US dollar. However, there is a conundrum, if the world was so sure of the relative strength of the American economy, surely the yen should be selling off more against the dollar. For CLSA the real test is yet to come when the new fiscal year in America begins on 1 October and the revival of US economic growth that is so hoped-for, does not materialize... and given the correlation in the chart below, it is clear that there is only thing that matters - the US 10Y rate.
Via CLSA's GREED & Fear Report (Chris Wood),
Not so surprisingly, the normalisation scare has picked up momentum over the past week with renewed focus on the ‘panic’ in the emerging market debt space and related equity markets.
the practical reality is that the emerging world, including Asia, will remain vulnerable to further selling so long as markets are anticipating normalisation of American monetary policy and a related strengthening in the US dollar. This for now appears to be the case with the further pick up in the 10-year Treasury bond yield over the past week, even if this latest normalisation scare is different from the one that hit in June in that it has not been accompanied as yet by a sell-off in gold.
If the world was so sure of the relative strength of the American economy, surely the yen should be selling off more against the dollar. This suggests to GREED & fear that the normalisation story, which has been driving market action all this year, may be nearer an end than the beginning. Still the real test of it will come when the new fiscal year in America begins on 1 October. For then, based on the Federal Reserve’s forecast, the American economy is meant to accelerate with the end of so-called ‘fiscal drag’.
If this does not happen as anticipated, then the issue will become whether the Fed is really prepared to exit unconventional monetary policy. That seems most unlikely under a Fed led by Billyboy or his deputy Janet Yellen.
But the markets will be less sure under a Fed led by President Obama’s seeming favoured candidate, Larry Summers. This is why the uncertainty posed by an Obama decision to nominate Summers has the potential to trigger more of a normalisation scare in the form of a further back up in Treasury bond yields and a further sell-off in equities, be it Asian equities or American equities.
For now, the ongoing normalisation scare and related back up in sovereign bond yields is causing research departments in Asia to recalculate their valuations based on the increase in the so-called “risk free” rates. Thus, the Indonesian 10-year rupiah government bond yield is up from 5.19% to 8.46% since the beginning of the year.
But the key driver here, for the most part, is the action in the US Treasury market. In this respect CLSA’s technical analyst Lawrence Balanco makes an interesting point in his latest weekly. This is the correlation between the US 10-year Treasury bond price and emerging market assets so far this year. That is 0.93 with emerging market bonds, 0.81 with emerging market equities and 0.71 with emerging market currencies.
GREED & fear’s base case is that American economic growth does not improve materially over the current post-2008 trend real GDP growth rate of 2.2%.
This is why the US 10-year Treasury bond remains the key price to watch globally.
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