Tapering, a game-changer?
The start of tapering in January 2014 is not expected to significantly change our global economic outlook. Nevertheless, it might have negative consequences for the bond markets of vulnerable countries, both in the emerging world and the eurozone.
Yesterday, the US Federal Reserve (Fed) decided to start tapering its third round of quantitative easing (QE). Starting in January, the monthly asset purchases by the Fed will be lowered from $85bn to $75bn. Continued recovery on the US labour market and approval of the two-year budget deal were main drivers behind this decision. Based on Fed chairman Bernanke’s expectation of future similar ‘taper’ steps, Rabobank expects the Fed will have ended its QE3 program by end 2014. The gradual unwinding of US monetary policy will undoubtedly have an impact on several regions across the globe. In the next sections we describe these effects.
Emerging markets: separating chaff from wheat
When the notion of tapering was announced in late May 2013, financial conditions in emerging markets tightened significantly. Higher yields in advanced economies and less liquidity to go around forced investors to make calculated choices. Risk entered the equation again. Bond yields rose, stock markets fell and currencies depreciated. However, not all emerging markets were equally affected. Those with weaker fundamentals suffered most. Countries with, for instance, (large) current account deficits and/or (large) budget shortfalls, such as India, Indonesia and Turkey, witnessed a heavy impact. The impact on emerging markets with stronger fundamentals was (more) limited. Moreover, countries with a relatively large and open financial markets suffered most, as the impact of QE and thus also of the reduction thereof was transmitted more easily to these countries.
The clearest impact of the announcement by the Fed yesterday on emerging markets was a further depreciation of their currencies. This was due to that fact that the announcement had a strengthening effect on the US dollar against all currencies. As a result, many emerging market currencies, such as the Indonesian Rupiah and the South African Rand, hit their lowest point since September today.
However, overall, we expect that the impact of a gradual tapering in 2014 will be limited, except for the most vulnerable countries. In the past year, emerging markets’ stock markets and currencies have already experienced a major correction, and are thus far less overvalued. The fact that stock markets in emerging markets are showing mixed results today strengthens this view. That said, financial conditions are likely to continue to come under pressure as tapering continues. As before, emerging markets with weak fundamentals are more at risk than others. On the other hand, better economic performance in the US, which will go hand in hand with continued tapering, will benefit export sectors of many emerging markets, either directly or indirectly.
Figure 1: Emerging markets financial conditions
Source: Reuters EcoWin
Eurozone: muted impact
Moving towards the eurozone, we maintain our view that a gradual US tapering in 2014 will, on balance, have a muted impact on the eurozone economy. Indeed, higher long-term interest rates in the eurozone may, in the current phase of recovery, hamper growth via lower domestic demand. However, on a positive note, we expect the euro-dollar exchange rate to depreciate in the course of next year on account of an increased interest rate differential between the US and the eurozone. A cheaper euro will support eurozone exports. Keep in mind that some eurozone member states will be better able to benefit from the improvement in price competitiveness than others. As their share of exports in their total value added is relatively low, Southern Europe will benefit less. Besides that, we stress that higher capital market rates entail a threat to peripheral countries regarding their debt sustainability. Last summer, for example, political instability in Portugal resulted in volatility and upward pressure on yields of Portuguese government bonds (figure 2). Although the initial market impact on European government bonds has been limited until now, against a background of further tapering, we should take into account that news about a disappointing recovery or political instability might bring the periphery back on the radar of financial markets.
Figure 2: Volatile Portuguese yield
Source: Reuters EcoWin
The global picture
Looking at the global picture, we do not believe the start of tapering in January is a game-changer for our economic outlook, as moderate tapering in 2014 was already part of our base case scenario of a modest global recovery next year (figure 3). We note that any reduction of QE will go hand in hand with a recovery of the US economy. However, as mentioned above, some countries are more vulnerable to the impact of tapering, both in the eurozone and the emerging world. For these countries, the net effect of both higher US growth and harsh financial conditions depends on the extent to which these countries can benefit from higher US imports. Two large uncertainties in gauging the negative impact of tapering exist. First, it is difficult to say to what extent financial markets have already priced in the effects of tapering since the first announcement by Bernanke on the 22 of May. Second, the impact on individual bond markets and the resulting effect on their real economy are highly dependent on the pace of tapering. Therefore, although its direct impact on global GDP is expected to be limited, all eyes will remain on the US recovery.
Figure 3: Modest global recovery
Source: Reuters EcoWin