If you have been following the markets over the past few years, you would probably be familiar with how the Fed’s bond buying programme and mission to drive down borrowing costs have been key factors behind the bullish run in equities.
The course of cheap money has propelled many global indices to new highs, including that of the S&P 500, Dow Jones Industrial Average and the Hang Seng Index. Singapore’s Straits Times Index has also been buoyed to make new seven-year highs.
Come the Federal Open Market Committee (FOMC) meeting at the end of October, the plug will be pulled on the remaining US$15 billion per month in its bond buying programme, which kicked off in September 2012 at $85 billion per month.
The pessimistic view is that once the Fed steps back, global stock markets will lose their support and collapse. Those who are more optimistic believe that these markets will just lose a bit of steam and take a pause as businesses build on their fundamentals.
So what happens when the music stops?
‘Taper terror’ and ‘taper tantrum’ have been the tag phrases being bandied around on news headlines as investors get flashbacks of the painful market contraction in 2013.
Back in May last year, many were caught off guard when former Fed Chairman Ben Bernanke indicated that the Fed might begin unwinding QE3. The news put the brakes on the advance of stocks globally, nudged long-term interest rates higher and sparked a round of volatility.
Emerging markets were among the worst hit, particularly countries with large account deficits. For instance, India saw huge capital outflows and sharp currency depreciation.
In Asia, this makes India and Indonesia – along with Brazil, South Africa and Turkey – countries to watch. These are the unfortunate members of the ‘fragile five’ club, a grouping of emerging market economies overly reliant on foreign investments to cover current account deficits and finance growth. This makes them vulnerable to capital outflows as a result of improvements in developed economies, investors are selling emerging market currencies and move into the greenback.
Many countries have since learnt their lessons from the tapering tantrum episode, and current account positions across the region have broadly improved. The region has accumulated vast quantities of foreign exchange reserves and its banks are sufficiently well capitalised to act as deterrents for any attempts to force currency meltdown.
For example, India’s trade deficit has dropped more than 6 percent of gross domestic product to 1.4 percent. Among the Southeast Asian countries that suffered during the taper tantrum in 2013, Thailand has reversed its deficit to surplus, while Malaysia has turned around its previously shrinking surplus.
However, Indonesia is not out of the woods yet. Amid sluggish growth, its deficit of 3.5 percent of GDP is the largest in the region. This makes the Rupiah the most vulnerable currency as it needs to attract inflows to finance the deficit. By extension, Indonesian stocks are likely to be weighed down by this gloomy sentiment.
While that could potentially spark some jitters across the rest of the region, there are also factors that will help put a lid on concerns.
Even with higher US interest rates, investors may hold on to their investments if they are convinced that there are better policies in places and are optimistic over structural reforms. In this scenario, regional equities will also be less prone to a sell-off.
Another factor that might help offset any ripples from the end of QE3 is the flood of money from the Bank of Japan and further easing from the European Central Bank.
Watch for ‘Considerable Time’
While the ending of QE3 is pretty much on track for end of October, there is less certainty around the timing of the hiking of US interest rates.
One key word that market watchers have been fixated on has been ‘considerable time’, a phrase used by the FOMC to describe how long rates would stay low after its stimulus ends.
In the latest FOMC meeting in September, that phrase remained in Fed Chairwoman Janet Yellen’s rhetoric, though the market consensus forecast is now more heavily favouring a rate hike in mid-2015. The catch is that she has warned the hikes could come earlier than expected if the economy recovers faster than expected, particular hinging on data around the proportion of full-time jobs to part-time jobs and wage growth.
With an impending hike, it may be worth noting that many periods of Fed tightening over the past decades were precursors to volatility in emerging markets, thanks to the mass flight of capital. For example during the early 1980s, the tightening of rates then triggered an ‘international debt crisis’, while in 1994 we saw the ‘Mexico peso crisis’.
However, many market watchers are betting that this time things will be different and the impact on Asian markets will be less significant.
Besides the better fundamentals to absorb the impact, the potential US rate hike has been one of the most widely anticipated moves and to some extent is likely to have already been priced into the markets. Also, thanks to the prolonged jawboning, if as promised, the rate hike is gradually rolled out in response to improving US macro data, we are unlikely to see many surprises.