Last fortnight, I wrote about the uncertainty in the commodity cycle going forward. On the macro-economic side, the picture has just become more complicated, with the release on Wednesday of US inflation numbers for March. Consumer prices rose by a larger-than-expected 0.6% and core CPI was at 0.4%. This is the highest monthly rate of increase in the past five years. On an annualised basis, the numbers are upwards of 3%, higher than the Fed target of 2-2.5% per annum.
US bond and equity markets typically fall when inflation picks up. US equity markets have lost 7-10% since the beginning of the year, but surprisingly, the bond markets have firmed up. Typically, the interest rate tightening cycle in the US continues for a year or two. During this period, most asset prices come under pressure. There is a flight to quality assets and high- yield bonds and emerging market stocks and bonds are hit hardest. When the tightening cycle continues longer than expected, vulnerable emerging market economies sometimes succumb to the sustained pressure and this could lead to sudden and unexpected events.
Examples of this are to be found in the previous tightening cycles of 1994 and 1997. In 1994, Mexican local currency-denominated short-term paper, called Cetes, was all the fashion with US investors. The Fed started raising rates in February of that year and by December, Mexico, facing significant capital flight, had to finally devalue the peso, leading to large losses among US institutional investors. It turned out that most of the locals had smartly already exited the market and moved their assets into the US!
In the 1997 cycle of Fed tightening, South-East Asian countries, which had similarly been dependent on foreign inflows, suffered a fate similar to Mexico’s. The Asian tigers were laid low by shifts in fund flows out of their countries. By 1998, the Brazilian currency came under similar selling pressure and the country had to take quick, but painful, action. By the middle of 1998, Russia, which had seen huge inflows into their local currency debt market, called GKOs, could not handle the sustained outflows and the resultant pressure on their currency. The local debt market collapsed, leading finally to a debt restructuring and large losses among foreign investors.
The current era is somewhat different. US interest rates have been low for longer than anticipated, as inflation remained muted despite the Fed pumping liquidity into the system, post 9/11. While the US economy did not do all that badly during this time, job creation, economic vitality and optimism were missing. There was a feeling that growth was driven less by fundamentals and more by liquidity-induced consumer spending.
Now, inflation appears to be picking up, even while growth slows further. While the Fed started the process of increasing rates several months ago (from the extremely low level of 1%), the question now is—how much further do rates need to rise to control inflation? And what will that do to asset prices the world over, particularly coupled with a slowing US economy? As liquidity is sucked out of the system over a longer period of time, will there be other structural imbalances that will be exposed, a la Mexico in 1994 and Brazil, Russia and South-East Asia in 1997-98?
• Long Fed interest rate tightening cycle affects emerging market economies • Fed tightening affected S-E Asian nations dependent on foreign inflows
The obvious candidate for some action is the Chinese renminbi, which is probably overvalued, and the US dollar, which will face pressure on the one hand from the rising US current account deficit, but will get support from potentially higher interest rates. The paradox is that while short-term rates in the US are rising, long-term rates are actually coming down from their recent highs!
The implications for India are clear. The Indian stock market is more and more liquidity driven, and more specifically, FII liquidity driven. As US markets fall, or as US interest rates rise and liquidity becomes scarcer, FIIs are likely to have less overall money to invest and will become more risk-averse, as the flight to quality mentality sets in. As that happens, Indian markets will be under pressure. Whether Indian economic fundamentals and domestic fund flows can help decouple the Indian market from global developments remains to be seen. But that is why developing a strong domestic asset-gathering system is so important.