The 3 Big Lies Right Now
There appears to be 3 big lies (among many other smaller ones) currently driving the flow of speculative capital around the world. First, Bernanke said the Taper was off due to 'worsening' financial conditions (except financial conditions remain very near all-time highs). Many mean-reverting extrapolators are calling for a renaissance in emerging markets and Asian growth that will lead us out of this 'temporary' slowdown (except consensus growth expectations for Asian economies are tumbling in reality) and most people assume US economic 'escape velocity' growth is around the corner and the Fed will normalize policy 'just right' (but a glance at Eurodollar futures suggests the market is far more dovish than previous tightening cycles would suggest). With normaliation implying 600bps rates rises, we suspect the reality of these 'lies' will come back to bite sooner rather than later.
Via Bloomberg Briefs' Michael McDonough (@M_McDonough)
During his post-FOMC press conference, chairman Bernanke indicated that tightening financial conditions played a role in the committee’s decision to hold off tapering.
Meanwhile, the real-time Bloomberg U.S. Financial Conditions Index remains close to its historic highs, indicating steadily improving financial conditions in the U.S., contradicting the chairman’s concerns.
Since 1990, the Fed’s three major tightening cycles lasted an average of 16.7 months with the target rate increasing an average of 300 basis points.
Eurodollar options, an instrument used by investors to bet on future Fed rate moves, suggests this next tightening cycle will begin in mid-2014 with the target rate increase less than 200 basis points by the end of 2016, well below the historical average. Given fundamental data in the U.S., it may be more likely that the Fed won’t begin tightening until 2015, though by a higher magnitude than currently anticipated by the market. With a neutral Fed funds rate of about 4 percent, a 400 basis point tightening cycle remains possible as unemployment and inflation move towards the Fed’s accepted levels.
The U.S. Federal Reserve’s surprising decision to delay reducing the pace of its asset purchases, coupled with recovery signs in China’s economy, may be providing a false sense of optimism for emerging markets investors, especially in Asia. The Bloomberg consensus forecast for Asia’s 2014 GDP growth has slipped steadily during the past four months to 6.3 percent as of Sept. 23 from 6.9 percent at the beginning of May.
As tapering begins and U.S. economic data improves, investors will begin to price in eventual normalization of the Fed funds target rate, leading to a sustained increase in U.S. Treasury yields. This would adversely affect capital flows into many emerging market countries, leading to deterioration in those countries’ financial and economic conditions. Financial conditions in economies with wide current account deficits are especially at risk.
So 3 big lies... and it seems (for now) BTFATH is flailing...
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