Crashed
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Propping Up the Markets? The Association (Possible Spurious) of the S&P 500 and the Fed’s Balance Sheet
Source: Federal Reserve Economic Database (FRED).
Investors looked for higher yields not just in US equities but further afield. Dollars were cheap for everyone. Any investor who was willing to take a gamble on exchange rate movements could borrow cheaply in dollars and invest in high-yielding emerging markets. Assuming the dollar did not sharply appreciate before the debt was due, it would be a profitable carry trade.4 By the middle of 2015, governments and businesses outside America would pile up $9.8 trillion of debts denominated in dollars.5 Much of this went to rich, developed world economies. But $3.3 trillion was owed by emerging market borrowers, both government and private. From the point of view of the yield-chasing investor, the more exotic the securities the better. In September 2012 Zambia issued its first dollar-denominated bond. With a modest 5.6 percent coupon, a $750 million offering attracted more than $11 billion in bids.6 A year later a state-backed tuna-fishing venture in Mozambique raised $850 million. Altogether, African sovereign borrowers garnered $17 billion in bond funding in 2012–2013.7 In May 2013 the boom reached its peak, with the $11 billion ten-year bond issued by Petrobas, Brazil’s state-owned oil company. It was the largest bond issue ever by an emerging market corporation. Demand was so great that the yield on the Petrobas issue fell to as little as 4.35 percent, less than many sovereign borrowers.8
This global interest in emerging market debt was exciting from the point of view of the borrowers. But it also exposed them to serious risks. Huge, aggressively managed funds crowded into tight markets. As the IMF pointed out, given that the largest five hundred asset management companies had more than $70 trillion in their portfolios, a 1 percent reallocation implied a flow in or out of an asset class of $700 billion. This was enough either to swamp or to starve the emerging markets. The withdrawal of funds that had caused such stress in 2008 around the periphery of the world economy had amounted to only $246 billion. The unprecedented inflow that transformed the outlook of those same economies in 2012 was $368 billion.9 This disproportion created risk for the borrowers. But it was potentially bad news for the investors as well. If there was to be a sudden wave of withdrawals, the small size of emerging financial markets would amplify the stampede effect.10 If the Fed reversed its policy and money flooded back to the United States, who would be the first to sell? Who would get out without fatal losses?
According to BIS data, professionally managed funds increased their stake in emerging market equity and bonds from $900 billion to $1.4 trillion between 2008 and 2014.11 Set against global totals running into the tens of trillions, those were not huge numbers. But they were comparable to the stock of toxic subprime assets, which had caused such havoc in 2007–2008, and to the debts of Greece, Spain and Ireland, which had destabilized the eurozone in 2010–2012. After subprime and after eurozone sovereign debt, were emerging markets to be the next volume in the “trilogy” of debt crises?12
Not for nothing the financial officials of booming emerging markets like Brazil complained about the influx of hot money from the United States. At the G20 in Seoul in November 2010 they had lambasted Bernanke for adopting QE2, dropping US interest rates and allowing the dollar to slide. By 2013 many emerging markets had gone beyond the war of words to adopt capital controls. Brazil, South Korea, Thailand, Indonesia all took steps to slow the inflow of funds and curb the appreciation of their currencies. Fifteen years earlier in the heyday of the “Washington consensus” this would have put them beyond the pale. Restraining international capital movement was a retreat from the most fundamental liberalizing policy of the 1970s and 1980s. But the advocates of the market revolution had foreseen neither the emerging market crises of the 1990s nor monetary policy on the scale of QE. Faced with the giant flux of the global credit cycle, amplified by spillover effects from the Fed’s crisis fighting, controls on capital inflows were grudgingly accepted as a pragmatic necessity, even by the IMF.13 It was, the Economist magazine commented, “as if the Vatican had given its blessing to birth control.”14
II
As far as the markets were concerned, everything depended on when and how the Fed changed course. Back in September 2013 Bernanke had made the giant bond-buying program of QE3 that was soaking the world in dollar liquidity conditional on America’s labor market. He had promised that interest rates would stay at rock bottom until unemployment fell below 6.5 percent. In the spring of 2013, with the US economy beginning to edge toward that threshold, the Fed began to drop hints. The moment was approaching at which it would consider slowing the pace of asset purchases. It was a delicate game. The Fed didn’t want to “taper” too abruptly. The labor market was not yet fully recovered. The sluggish recovery that was troubling Larry Summers might not withstand a sudden spike in interest rates. For the investors, on the other hand, it was crucial to be ahead of the game. If they knew that the Fed was going to raise rates in the foreseeable future and that bond prices would fall, they wanted to be the first to sell. Of course, no one could know for sure whether the Fed would indeed begin to taper or precisely when. So another reason to sell was to test the Fed’s resolve. As Richard Fisher, chair of the Dallas Fed and himself a former hedge fund manager, put it to the Financial Times in characteristically colorful terms: “Markets tend to test things. . . . We haven’t forgotten what happened to the Bank of England [when George Soros broke the pounds peg in the ESM in September 1992]. I don’t think anyone can break the Fed . . . but I do believe that big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”15 For Fisher, given this tendency to herding, it “made sense” for the Fed “to socialise the idea that quantitative easing is not a one-way street.” But given the likely impact on the fragile recovery of a large step up in interest rates, Fisher did not expect Bernanke to go from “Wild Turkey to ‘cold turkey’ overnight.” The feral hogs should beware of getting ahead of themselves.
On May 22, 2013, Bernanke took the plunge. He told Congress, “If we see continued improvement and we have confidence that that is going to be sustained, then in the next few meetings, we could take a step down in our pace of purchases.”16 The markets skipped a beat. Then, at 2:15 p.m. on June 19, 2013, Bernanke made a more specific announcement. Conditional on continued positive economic data, the FOMC would vote on scaling back its monthly bond purchases from $85 billion to $65 billion at the upcoming September 2013 policy meeting. The bond-buying program might wrap up entirely by mid-2014. Despite weeks of preparation, Bernanke’s statement triggered a full-scale “taper tantrum.” In a matter of seconds yields surged from 2.17 to 2.3 percent. Two days later they had risen to 2.55 percent and would peak at 2.66 percent. These were small changes in absolute terms, but amounted to an increase in interest costs of almost 25 percent and inflicted a correspondingly serious capital loss on bondholders. US equity markets reacted in sympathy, losing 4.3 percent in a matter of days.
In the emerging markets Bernanke’s May announcement had already been enough to provoke a violent reaction. If the Fed reduced its purchases, bond prices began to ease and yields nudged upward, the emerging markets would come under a double pressure. Not only would their rates have to adjust by at least the same amount as the United States, but they would face an amplification effect through the exchange rate. As the Economist explained, a “stock of dollar debt is like a short position,” i.e., a speculative position assuming that the dollar exchange rate will either remain level or fall.17 A Fed interest rate increase signaled not only higher borrowing costs but a likely upward movement in the dollar. Exposed emerging market borrowers would run to cover their dollar exposure, amplifying the currency adjustment and increasing the pressure on other dollar borrowers. Already in the spring of 2013, as markets began to worry about Bernanke’s next move, the emerging markets felt the pressure. For the emerging markets the funding boo
m was over. The exchange rates of what Morgan Stanley dubbed the “Fragile Five”—Turkey, Brazil, India, South Africa and Indonesia—declined precipitously. Western investors pulled their money.18 Interest rates went up to counter the “vacuum cleaner” effect of Fed policy.19 Capital controls put in place to curb excessive inflows did not prevent foreign money from leaving. But they limited the scale of the damage. As one Brazilian central banker remarked: “We knew this was going to come, and we prepared ourselves.”20
Stern American observers noted that the global credit cycle was not fate.21 Countries that had allowed their currencies to appreciate had been subject to a smaller inflow of funds. Nor, when the global credit cycle reversed, did everyone lose funding at the same pace. Among the emerging markets the hardest hit were those with less than fully sound financial positions. The Fed tightening was going to be tough for everyone, but if they did not put their budgets in order, they had only themselves to blame.22 That made sense as a moral message and it conveniently deflected responsibility from the United States. It was up to the emerging markets to look after themselves. But it did not turn out to be well supported by the evidence. The biggest losers among the emerging markets, in fact, tended to be those that had attracted the largest foreign inflows, which also tended to be those with the most solid financial records.23 In any case, home truths about fiscal discipline came late for those now facing a funding squeeze. Some buckled down. Raghuram Rajan, the onetime critic of financial market euphoria and former chief economist of the IMF, now earned his spurs as India’s central bank governor by raising rates and stabilizing the rupee.24 But the taper tantrum was a test of political as well as financial resilience. Not all governments responded with equanimity to such abrupt external pressure.
When QE taper talk hit the Turkish currency in May 2013, President Erdoğan was struggling with a dramatic domestic challenge as protesters clashed with riot police in Istanbul’s Gezi Park.25 Erdoğan had no doubt about how to interpret this coincidence. It was no coincidence at all. The internal political and external financial pressures on his government were part of a “conspiracy by unspecified foreign forces, bankers, and international and local media outlets” to push for regime change.26 For Erdoğan, the pressure was being applied to all the countries that dared to claim a new place for themselves on the world stage—countries like Brazil and Turkey. “[T]he symbols are the same, the posters are the same, Twitter, Facebook are the same, the international media is the same. They are being led from the same center . . . the same game, the same trap, the same aim.” The masters of social media in Silicon Valley, the crusading liberals at the State Department and the Fed were all in on it. In an inflammatory speech he denounced the connections between Turkish private banks, international capital groups and, according to at least one report, Israel. “Who won from these three-week long [sic] demonstrations?” President Erdoğan asked. “The interest lobby won. The enemies of Turkey won.”27 Foreign experts might insist that Turkey had simply to put its economic house in order, but Erdoğan had other ideas. Frustrated with the EU’s failure to proceed with Turkish accession negotiations and the Obama administration’s failure to act in Syria, he lurched toward Moscow. Turkey, Ankara let it be known, would welcome membership in the Economic Cooperation Organization founded by Russia and China in Shanghai.28 Compared with the capricious West, the Russia-China axis seemed to promise stability.
At the G20 in Saint Petersburg on September 5–6, 2013, as the world waited to see how the Fed’s Open Market Committee would vote, the tone was more measured than that from Ankara, but the message was loud and clear. The Fed needed to acknowledge that everyone, including the United States, was living in an “interdependent world.” The finance ministers of both Brazil and Indonesia demanded more clarity from Bernanke. China, which was exposed to the United States not just through trade but also through its giant dollar bond holding, was no less vociferous. As one official spokesman put it: “Given that U.S. monetary policy has a huge influence on emerging markets and the global economy, we hope that U.S. monetary policy authorities, whether exiting or scaling down stimulus, will not only consider the U.S.’s own economic needs but also think about economic circumstances in emerging markets.”29 Rajan was the emerging market spokesman with the highest personal profile in the United States. During the crisis of 2008, he reminded America, the emerging markets had undertaken “huge fiscal and monetary stimulus” in support of global growth. The industrialized countries could not now “wash their hands . . . and say we’ll do what we need to and you do the adjustment. . . . We need better cooperation and unfortunately that has not been forthcoming so far.”30
“Interdependence” was one of the nostrums of the age of globalization. And it was all very well to call for greater cooperation. But why should the Fed listen to such demands? In 2008 it had provided liquidity to the entire world economy. Now it was doing its best to sustain the revival. But its mandate was national. It was responsible for the American economy, not the wider world. As far as the Fed was concerned, the really compelling argument was that of blowback. This was what had clinched the case for the massive swap line action in 2008. And this was the point made in the fall of 2013 by IMF managing director Christine Lagarde. The reverberations from the Fed’s huge monetary shocks, she warned Washington, “may well feed back to where they began,” i.e., back on the United States.31 But it was one thing for the Fed to acknowledge that Europe’s megabanks might bring the house down. It was quite another to make the same claim for the emerging markets. Looking at the numbers, no one could seriously argue that the business cycles of Indonesia or India had much impact on US financial stability.32 The interdependence of the global age was all pervasive, but it was emphatically not symmetrical. Some received shocks, others dealt them out.
In any case, given that Republican insurgents were in the process of shutting down the federal government, and were eyeing the IMF’s budget as a potential hostage, it would have been politically disastrous for the Fed to acknowledge that it was conditioning its latest policy move on business conditions in Indonesia. Instead, the protests from the emerging markets provided a convenient occasion for the Fed to make a stout show of American patriotism. As Dennis Lockhart, president of the Atlanta Fed, reassured Bloomberg TV in August 2013: “You have to remember that we are a legal creature of Congress and that we only have a mandate to concern ourselves with the interest of the United States. . . . Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.” James Bullard of the Saint Louis Fed emphasized the same point: “We’re not going to make policy based on emerging-market volatility alone.”33
III
Then, on September 18, came the Fed’s long-awaited decision. After the buildup since May, the FOMC announced that it would leave interest rates where they were and continue bond buying at the current rate, pending “more evidence that progress will be sustained.”34 The taper, the prospect of which had been giving the markets jitters since May, was off.
The decision to change nothing unleashed a frenzy of interpretation not about the likelihood of tapering but about why it had not happened. Were the doves on the Fed board resisting an interest rate shock? Had Bernanke got cold feet? Was he kicking the can down the road for his successor to deal with?35 Or was the Fed consistent in its policy, but bad at forecasting? Between the spring of 2013, when it began to think about tapering, and September, when it decided to postpone it, the Fed had adjusted its forecast for economic growth sharply downward.36 If the economy was recovering less strongly than expected, this would rescue the Fed’s reputation as a consistent policy maker, but at the price of undermining confidence in its forecasts and highlighting the downturn in expectations. Or was the Fed neither cowardly nor a bad forecaster? Was it playing a subtle tactical game? If it was committed to ensuring that the US economy completed its slow recovery without interruption from a premature and violent increase in rates,
it needed to know how severely bond markets would react to a reduction in monetary stimulus. The evidence of the taper tantrum in June 2013 was clear. The markets were impatient. Investors would rapidly tighten credit conditions on any hint of movement by the Fed. If the Fed believed that what was necessary was something more gradual, then after the initial tapering announcements in May and June, it needed to shock markets a third time in the opposite direction, letting them know that though tapering was coming, it was not a one-way bet.37
Four different interpretations: Fed politics, Fed weakness, Fed forecasting error, Fed game playing. Which was it? How were markets to know, and without knowing, how were they to react? Given the Fed’s hesitancy, one might have expected the bond vigilantes to take up the fight. There was profound hostility to Bernanke among the more militant investor crowd. In October 2013 Larry Fink, the CEO of BlackRock, the largest asset manager, accused the Fed of feeding “bubble-like” market conditions.38 His chief investment officer for fixed income complained that there were “tremendous distortions” building in interest rates.39 But there was no unanimity in the market. Bill Gross at Allianz-PIMCO argued that investors should accept the inevitable. If the aim of the Fed was to engineer a gradual exit from the gigantic debt bubble of the boom years—what Ray Dalio at the Bridgewater hedge fund called “beautiful deleveraging”—bond investors would have to accept that this came at their expense.40 They should abandon their expectation of an imminent increase in rates. “Right now the market (and the Fed forecasts) expects fed funds to be 1 percent higher by late 2015 and 1 percent higher still by December 2016. Bet against that. . . . In betting on a lower policy rate than now priced into markets, a bond investor should expect a certain pastoral quietude in future years, much like that grazing cow, I suppose. Not that exciting, but what the hay, it’s an existence! . . . Mother Nature nor Mother Market cares not a whit for your losses nor your hoped for double-digit return from an equity/bond portfolio that is priced for much less. Be a contented cow, not a voracious crow, and graze wisely with increasing certainty that the Fed and its forward guidance is your best bet for survival.”41