Following Fed Chair Powell’s speech, content editor Matt O'Brien takes a look at how rising rates could dampen investment and risk defaults across EMs.
To no one’s surprise it appears the United States Federal Reserve will continue to hike short-term interest rates next month, followed by another likely increase in December. For the time being, the central bank will allow its bloated balance sheet to gradually shrink as the securities that were acquired during its QE operations from several years ago are paid off, according to prepared remarks from Federal Reserve Chairman Jerome Powell this morning at the Jackson Hole symposium.
Both policy outcomes have huge implications for Latin America, other emerging markets and the dollar’s future.
The Fed Chairman has recently said leading up to this weekend’s gathering that central bank officials will more closely examine how to set policy around its balance sheet sometime in the fall.
“We are also allowing our securities holdings—assets acquired to support the economy during the deep recession and the long recovery—to decline gradually as these securities are paid off,” Chairman Powell said in reference to the central bank’s balance sheet. “As always, there are risk factors abroad and at home that, in time, could demand a different policy response, but today I will step back from these.”
Prior to this weekend’s central bank confab in the Grand Teton Mountains market players were hopeful that officials would provide clarity around the Federal Reserve’s balance sheet. Investors will also continue to parse central bankers’ language this weekend to detect hints that the pace of future rate rises might be reconsidered in light of President Donald Trump’s recent criticisms of Fed action.
Dallas Federal Reserve President Robert Kaplan said in an interview with media outlets this morning that moving rates toward the “neutral rate,” or “natural” or “equilibrium” rate, which is the federal funds rate that neither stimulates nor restrains economic growth, means 3 or 4 increases in short-term rates over the next 9 to 12 months.
“My colleagues and I are carefully monitoring incoming data, and we are setting policy to do what monetary policy can do to support continued growth, a strong labor market, and inflation near 2%,” Chairman Powell said.
The United States Dollar Index, DXY, extended losses in the morning after the chairman said there is no clear sign of inflation rising above 2% and that there were no signs of overheating. The DXY was down .4% to around 95.26 around 10:40 a.m. EST.
Volatility in the FX markets, which was triggered a couple of weeks ago by concerns with Turkey's external debt levels and political standoff with the US, prompted traders to sell off emerging market (EM) currencies and equities. The sell-off quickly stoked worries about the Greenback’s appreciation against other EM currencies and the White House’s draconian trade policies with major trading partners.
During previous global financial crises, the lack of sufficient foreign currency reserves in EM economies (EME) pushed international banks to withdraw short-term capital, which in turn set off corporate bankruptcies and balance of payment challenges. However, as the expression goes, this time is different. The concern this time is dollar-denominated bonds. Earlier this week I wrote about it here.
“Even though long-term investors are thought to be a stabilizing influence in financial markets, absorbing losses without triggering insolvency. However, we are reminded from time to time that such investors can have limited appetite for losses, and they can join in a selling spree,” state the authors of Bank of International Settlements (BIS) report. As rates continue to climb, bond investors usually dump lower yielding bonds for securities with better rates of return. This has a compounding effect to push up yields even higher.
“Even if the monetary authorities of a country hold large foreign exchange reserves, there is a sectoral disparity within the country, as it is the corporate sector which has done much of the borrowing. ... there is an uneven distribution within the economy,” the BIS report states in describing the current predicament. “The corporate sector itself may find itself short of financial resources and may cut investment and curtail operations, resulting in a slowdown of growth. … So, even a central bank that holds a large stock of foreign exchange reserves may find it difficult to head off a slowdown in the real economy when global financial conditions tighten.”
Turkey tops the EM list of those to have the highest foreign debt exposure to GDP. The list also includes Hungary, Poland, Chile, Argentina, Malaysia, South Africa, Colombia, Russia, Mexico, Brazil, Indonesia, Saudi Arabia, Thailand, China and India as top countries whose governments and corporates have borrowed heavily in international debt markets.
The question becomes, how much farther will rates go to the point that long-term investors en masse start dumping bonds? This will push yields up, put downward pressure on EM currencies, and inflate dollar-denominated liabilities, all of which can put M&A plans and projects on hold or cause them to be cancelled outright. Corporate defaults could grow when investors redirect capital flows back into developed economies, strengthening those currencies.
Rates and Tensions Rise
Several market mechanisms are pushing short-term rates higher: The deluge of short-term bonds that the US Treasury Department has issued to plug the growing fiscal deficit and reduction of the Fed’s bond portfolio. Before last week, the fed-funds rate had already spent several days at 1.92%, shortly after the Fed had raised its target range by 0.25 percentage point during its June policy meeting. Shrinking the portfolio by not replacing maturing bonds with new debt forces the Treasury to sell even more bonds to the private market as buying from the Fed diminishes. It could also cause the rate to rise by draining the reserves of banks and creating more demand for overnight loans.
Just how small the Fed’s bond portfolio needs to get to have a significant impact on the fed-funds rate is a matter of debate among analysts. Fed officials think this upward pressure on the rate is coming from market developments unrelated to the gradual runoff of the bond portfolio, which dropped to around USD 4.3trn in July from USD 4.5trn last fall. The runoff is draining bank deposits at the central bank, called reserves, from the system. At some point, this will probably apply upward pressure on the fed-funds rate.
With all of the political and market uncertainty swirling around the globe it will be hard to gauge how much farther the US dollar will appreciate, which puts pressure on EMEs as their respective currencies depreciate and dollar-denominated liabilities grow.
To compound problems, the small rise in the Fed Funds Rate, coupled with the contraction of bank reserves, is driving commentators to worry about a developing global liquidity crisis. Here, I think it helps adding a contrarian point of view since the Federal Reserve has pumped massive amounts of dollars into global markets since the Lehman Brothers collapse via QE.
Alasdair Macleod, head of research for GoldMoney Holding a global broker dealer in physical gold and precious metals, recently wrote, “From our analysis of dollar ownership, it is clear there is no shortage of dollars in foreign hands. These will be held through correspondent banks in the normal way. Furthermore, when it comes to trade settlement, there is no problem accessing them in the foreign exchanges for credible commercial borrowers. The lending decision is in the hands of correspondent banks, not the Wall Street behemoths. The problems facing countries like Turkey are entirely of their governments’ making, their irresponsible borrowing, and have little to do with dollar shortages.”
Various talking-heads, pundits and media took to twitter to criticize Chairman Powell’s speech as many felt it was too dovish.
Aside from currencies, commodities are feeling the pain as well. After bouncing back from the 2014/16 commodities bust things seemed rosy for the natural resources industry. Now, since the dollar has an inverse relationship with prices of globally traded commodities, such as oil, metals and agricultural products, thing look less certain. Just recently, the prices for sugar and coffee fell to the lowest point in a decade or more last Friday. Brazil is the world’s largest producer and exporter of both coffee and sugar, respectively, meaning that a weaker currency makes its crops more competitive and helps shield producers from low global prices. The USD/BRL exchange finished up around 4.7% in trading this week, breaking through the 4 reals for 1 US dollar ceiling. The LME index finished up roughly 3.8% this week, but down 1.6% on a monthly basis and 8% lower on a yearly basis.
Not only are the commodity driven economies of Latin America feeling pressure, but the natural gas business in the US too is being affected by Chinese tariffs of 25%. Writing for Oilprice.com, Irina Slav reported, “Chinese importers have already started reducing their purchases of U.S. oil products: in May, oil product exports to China hit a 10-month low at 141,000 bpd, with LPG exports in particular dropping to 52,000 bpd—the lowest in 11 months. To compare, the average U.S. oil product export rate was 229,000 bpd in 2017 and 181,000 bpd a year earlier.”
After delegates from the US and China could not make progress on trade negotiations on Thursday, Chinese Finance Minister Liu Kun told Reuters that, “China doesn’t wish to engage in a trade war, but we will resolutely respond to the unreasonable measures taken by the United States. If the United States persists with these measures, we will correspondingly take action to protect our interests.”
China is aiming to boost natural gas use by 15% of energy consumption by 2030, up from 6% in 2015.
The Dollar’s Future
Speaking of the Chinese, growing tensions with the Trump Administration over trade policy and its “America first” rhetoric has prompted the Communist government to shift strategies.
“The longer he maintains such policies, the more likely it is that markets will gradually move toward alternatives to the dollar. Eventually, the dollar would slowly bleed out, and America’s exorbitant privilege and global influence would evaporate,” writes Benjamin Cohen, professor of International Political Economy at the University of California.
“As it happens, China has already convinced Russia to accept the renminbi as payment for natural gas, where once it made such purchases only in dollars. And, more recently, China has started preparing the way for purchases of imported crude oil in renminbi. For example, earlier this year, it launched a new oil futures market in Shanghai, which seems intended to establish a renminbi-denominated price benchmark alongside Brent and West Texas Intermediate crude. If successful, the Shanghai market could trigger a shift of payments for other traded commodities as well–all at the dollar’s expense.”
China’s trade and investment ambitions throughout Latin America are well documented, having established an exchange of oil for loans to Venezuela, Ecuador and others.
The Chinese are also looking west, deepening relationships with other nations, some of which are not exactly allies of the US. China has agreed with Iranian officials to exchange oil for yuan, which can be hedged for gold through futures markets. India too is paying for Iranian oil with commodities rather than dollars. Turkey is also an important partner in China’s silk road project while a natural gas pipeline now connects Russia and China.
Other analysts have grown concerned over Russia. The Siberian nation, the largest exporter of natural gas by far, has been selling down its dollar reserves in favor of physical gold. It has also has established a bank settlement system alternative to SWIFT, linking into China. The USD/RUB exchange has jumped 15.23% on a yearly basis while the USD/CNYhas traded higher 3.35% over the same period.
“And both Russia and China have been investing heavily in gold to reduce their reliance on dollar-denominated reserves. Between them, the two countries have already bought some 10% of all the gold available on the world market. So, despite today’s dollar appreciation, a weakening greenback may be in store over the long term. Far from making America great again, Trump seems to be hastening its economic decline,” Cohen states.
Will Dollar Bonds Rock Corporate Latin America?
Previous financial meltdowns, such as the Asian Financial Crisis in 1997 and the 2008 Great Recession, saw international banking flows hardest hit while foreign direct investment remained relatively stable, the BIS report found. The contagion effect of the Asian financial crisis, which began in Thailand in July 1997, spread to many other markets, such as Indonesia, Malaysia, South Korea, Philippines, Hong Kong, Singapore, and Taiwan. It even affected Brazil and Russia to some degree, although there is less clarity about the mechanisms by which the crisis spread beyond Asia. Among the outward symptoms of the crisis were exchange rate problems, such as currency speculation and large depreciation of currencies, capital flight, and financial and industrial sector bankruptcies. However, recovery was surprisingly swift and all these countries exhibited positive growth by the second quarter of 1999. “When looking at the maturity composition of international claims in Asia, most of the international bank lending … during the run-up … represented ‘hot money.’”
When the bubble popped, central banks found they lacked the foreign currency reserves to stem the flow of hot money, precipitating contagion and collapse.
However, as I mentioned before, this time the worry is the rapid growth in US dollar-denominated debt securities issued by emerging market borrowers. The outstanding amount has been growing at an annual rate of 17% since last year.
“The growth in US dollar-denominated international bond issuance by EME borrowers has been very broad-based. The global wave has swept across all major EME regions. The post-GFC surge has been especially notable for several major EMEs – China, Brazil, Chile and Turkey,” the BIS report states. “A snapback could be accompanied by reversals of cross-border portfolio flows, threatening the sustainability of the high debt levels in many sectors. A snapback could have several potential triggers, including an inflation surprise, but the key is a sudden shift in risk assessments.”
Among Latin American countries vulnerable to rising rates are Chile, Mexico, Brazil and Argentina because of their high dollar-denominated debts both in the corporate and government sectors.
This fall, both Mergermarket and Debtwire will be hosting various conferences about the state of Latin American economies. I expect many of the panelists will discuss some of the macro issues I’ve discussed above. The Mergermarket Mexico M&A and Private Equity Forum will be held on Oct. 24 in Mexico City and the Andean Community M&A Forum will be held Dec. 5 in Bogota. The Debtwire Latin America Forum will be held on Dec. 11 in New York City.
Written by
Matt O'Brien
Content Editor
Acuris Studios
Follow Matt on Twitter @matt_obri3n or connect with him on LinkedIn.
Matt O'Brien is content editor for Acuris Studios, the sponsored events and publications division of Acuris, overseeing the research and editorial input for events. Matt works with the editors and reporters of Acuris' various publications to ensure the company delivers industry-leading conferences. He has spent nearly 13 years in the news and finance industries. Matt has a political science and international studies BA from Rutgers University.
