The great reversal? Is the era of cheap money ending?
- 12 June 2013
- From the section Business
It was US bonds last week, and now it's emerging economies' currencies, stocks and bonds that aren't having a good week.
A key index of emerging market stocks has fallen by 10% since its May peak. Brazil's stock market is down by more than 20%, which is often called a bear market.
The money outflows are clearly seen in their currencies. The Indian rupee fell to a record low earlier this week. The Brazilian and South African currencies hit four year lows and are at the level that they were during the global financial crisis. The Indonesian currency hit its lowest level in three years.
For that matter, US government bonds haven't been doing well either. Investors reportedly sold a record amount of global bonds last week, where two-thirds were US bonds. They also sold emerging market bonds.
What's the connection? A nervousness over the potential end of cheap money.
The impact may be vividly felt in emerging economies, which have experienced a volatile week of money leaving their borders. This is after cheap cash entered during the past few years seeking higher returns in these faster growing countries.
Money has also gone into developed economies' stocks and commodities, which also have experienced declines from their peaks.
The era of cheap money wasn't going to last forever. And it may not end any time soon. But, how well or poorly it all ends will depend on the way that major central banks conduct their "exit" from ultra-loose monetary policy.
Managing $12 trillion
Investors have described the outflows from emerging economies this week as "violent." The Indonesian central bank has even intervened to try and stabilise the flow of cash.
This tends to ring alarm bells. When a lot of money entered and then left before, some of these economies were destabilised.
Recall the 1998 Asian financial crisis. When there was a reversal of short-term capital flows, known as "hot money", in Thailand, there was a domino effect across the region and across the emerging world. Money left not only Asia but also Russia, Turkey and Latin America, even though they were not closely linked markets.
This time, the extraordinary amount of cheap money since the global financial crisis could mean that the Great Recession could end as the "great reversal."
Since the crisis, central banks have injected more than $12 trillion of cash. As an indication of how much money that is, there are only 15 countries in the world whose GDP or annual output exceeds $1 trillion.
The key question is whether these countries are better prepared this time to cope with money leaving their borders.
And some are - having built up foreign exchange reserves that can be used to bolster the value of their currencies if needed. Plus, financial regulation has improved, which is a result of learning the lessons of the Asian crisis.
End of cheap money?
There aren't indications that the Federal Reserve is planning to raise interest rates any time soon, and the Bank of Japan continues to reflate its economy. The ECB recently cut rates to a record low and several members of the Bank of England have been voting for further cash injections.
But, there is a growing concern (as seen in these markets) that the era of cheap money could begin to taper off in the US as the economy improves.
And, central banks may be contemplating their so-called "exit strategies."
"Exit" refers to central banks reversing their monetary actions, so unloading the trillions of dollars of assets (government bonds and others) from their balance sheets. They bought those in order to inject cash into the economy.
Plus, interest rates would then rise from the 0% or very low levels in major, developed economies.
A sign that investors are worried is the rise in US government bond yields. This is the interest rate that the US government pays to borrow, which has been low, partly because the Fed is a big buyer in the market. In fact, that was the aim of the Fed to lower interest rates to stimulate the economy.
But, the yield on 10 year US government bonds, the benchmark for borrowing costs, has risen to nearly 2.3% from below 2% just a couple of weeks ago.
This is still a far cry from being expensive to borrow. But, it reflects an expectation that interest rates will rise in the future. In other words, some are betting on the end of the current era of nearly 0% rates.
The record sell-off last week shows that some don't want to be left holding these bonds at all.
What exit looks like
This may be why. To "exit," a central bank will raise interest rates and sell their assets (government bonds and others) to re-absorb the money that they had pumped into the economy.
For instance, the Fed could decide to first raise rates and then gradually sell the government bonds that it owns.
But, once the Fed starts selling bonds, then it increases the supply that pushes down the price. So, the remaining bonds held by the Fed and those held by the private sector could be worth less. That may be why some investors don't want to own those bonds.
Of course, central banks don't want to disrupt the market too much, so will likely act at a moderate pace and specify their "exit strategy."
But, there are those who will worry about how central banks can take $12 trillion, or the equivalent of about one sixth of global output, out of the world economy in a smooth manner.
Five years on from the global financial crisis, it's perhaps unsurprising that investors think that central banks would begin to contemplate how to "exit" from very loose monetary policies.
But, looking around at the still weak world economy and the elevated unemployment rates in major economies, the last thing that we need is disruptive markets or worse, a big reversal of money flows that leads us into another crisis.