Monetary policy divergence becomes acute, a negative for EMs, risk assets

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Updated: December 19, 2015 7:44 PM

It was June of 2006, when US central bank, the Federal Reserve, had last hiked interest rates; it was from 5.00% to 5.25%. It was last Wednesday when they again did it, this time from 0-0.25% to 0.25-0.50% corridor...

US Fed rate hikeRaised the corridor for US Federal funds rate from 0-0.25% to 0.25%-0.50%. Fed fund rate is the rate at which banks in US lend funds to each other. (Reuters)

It was June of 2006, when US central bank, the Federal Reserve, had last hiked interest rates; it was from 5.00% to 5.25%. It was last Wednesday when they again did it, this time from 0-0.25% to 0.25-0.50% corridor, a nearly a decade apart. I presume many of the newcomers in financial markets have not experienced an actual rate hiking cycle from US Fed, so in a way we are in unchartered waters. I do not subscribe to a view that a rate hike can be dovish. It is akin to having a painless surgery. In our opinion US Fed has stepped up the policy divergence that existed between US central bank and rest of the world central banks and that is supremely critical. We have written a lot about role of monetary policy divergence for a good part of last 2 years and through them have shown how it has accelerated the rebalancing process in the world economy, excess demand-supply funded by too much debt.
US Fed announced the following:

Raised the corridor for US Fed funds rate from 0-0.25% to 0.25%-0.50%. Fed fund rate is the rate at which banks in US lend funds to each other. Raised the discount rate by 25 bps to 1%. Discount rate is the rate at which banks borrow funds from US Fed. Raised the interest they pay on excess reserves that bank’s park with Fed to 0.50%.

Removed the $300 billion upper cap on reverse repurchase agreements. RRPs is facility through which financial institutions (not just banks) can lend money to Fed at specified rate for a specified against collateral that US Fed is holding in their portfolio. This helps Fed to drain liquidity in order to push the effective Fed fund rate into the desired corridor. Before last hike the effective Fed fund rate was around 0.15%.

We would explain in a while how the draining of reserves in itself can cause a lot of heartburn for financial assets, especially the risky assets. Before that let us focus our attention on the larger stance of monetary policy and how it fits with macro picture. US stock markets have been the outperformers or so called leader of the world equity pack.

With EMs in dumps, European equities have struggled for most of 2015, as they have sizable EM linkage, through economy and financial flows. Corporate credit market has seen spread blow out, especially in the high yield sector, as commodity led stress has started to accentuate. In midst of all these US equities have held up well. However, things are beginning to change.

According to an interesting piece of research, Ned Davis Research, the quantitative research firm, on the basis of the median stock’s price/earnings and price/sales ratios, broader US stock market is more overvalued than 2000 or 2007 peaks. In the world of easy money, high valuation premium is well known fact. However, drivers to sustain that premium need to be in place for them to sustain. For US, corporate earnings growth has peaked, commodity led stress has made its way into the manufacturing economy. Industrial production growth has turned negative in November. Now the monetary policy has become a headwind. US cannot remain an island of abundance, with world economy floating above the 2% mark, that separates expansion from recession. We are already seeing US experience an extended cycle of weakest economic recovery since WW2.

US equity markets are throwing technical warning signs for some time now, and if they rollover to the downside in 2016 and experience a meaningful drop, then we can see sizable collateral damage to EM equities as well. It is to be noted that, after 7 years of courtship, 2015 seems to have seen a significant stress in the relationship between central banks and markets. It was started by Swiss National Bank, way back in January 2015, then all the hawkish jibes from US Fed, followed by ECB’s disappointment a few weeks back, now Fed’s lone ranger policy and last but not the least, Bank of Japan’s confusing last policy. With such massive valuation premium hiding in global financial assets, a not so kind affair between central bank and markets can get messy. We need to be in watch out for such changes, as major risk aversion process in world financial markets can tip the world into a recession.

Coming back to US Fed’s announcement on reverse repurchase agreements. US Fed, through QE 1-3 has over a period of time bought interest bearing securities from financial institutions. The cash that they have generated and paid to FIs (not just banks) have found their way back into the bank’s as deposit. Deposits in banks have translated into central bank’s balance sheet as required reserves and excess reserves. There is around USD 2-2.5 trillion of excess reserves parked by banks with US Fed, earning 50 bps per annum. Banks are allowed to hypothecate/rehypothecate the reserves that they have parked with Fed. It is an asset for the bank and hence it can be used to pledge with its counter parties as collateral it to fund their own positions vis-a-vis non-bank entities in financial markets. This was one of the major conduit through which US central banks asset purchase operation directly greased global financial markets over the past 8 years. Now with US Fed looking to drain reserves to move the Fed fund rate higher, the composition of the reserves changes.

Under the RRP operation, non- banks FIs are also allowed to bid. These investors, for example, money market mutual funds, have been ones who have deposited the cash with US banks which in turn has found its way into US Fed as two kinds of reserves. As the Fed shall conduct RRPs, these MMFs will park funds directly with Fed, thereby yanking deposits out of the banks. This will cause a drop in reserves held with the Fed by these banks. As the reserves drop, so will the rehypothecable assets fall, leading to shortening of the collateral chain and a strain on a source of liquidity for world financial markets. Remember, it is through the rehypothecation chain, that collateral can support value of credit which is a multiple of its assessed value. So the adverse impact of collateral drain or reserve drain can be significant. Additionally, bonds obtained by financial institutions under RRP from US Fed are not allowed to be pledged, so rehypothecation is not possible. All in all we would not be surprised if financial assets run into more rough weather over the larger part of 2016.

Back home in India, Indian Rupee has had surprisingly strong week, it has managed to strengthen by 1.1 % from the lows of 67.15 it touched a week back. Some transitory factors are supporting the Rupee, like, unwinding in the heavy dollar longs as stops have got triggered below 66.70 levels on spot and expectation of FII inflows into Indian debt on the back of increased limits next month. However, we expect RBI to step in and prevent a deeper slide in the pair. A range of 65.70/66.00 and 66.60/80 can unfold till year end. This year, Indian Rupee has a strong performers when considered against a basket of currencies. On a total return basis, Rupee is one of the top two strongest currencies.

Since Dr. Rajan took over, on a total return basis, Rupee has been a best performer. All in all it seems Dr. Rajan believes in a strong Rupee policy. So, though it may continue to depreciate against US Dollar but it shall do so a relatively slower pace than it peers in the world. We believe, RBI is not comfortable seeing the currency depreciate beyond 1.5-2% in a quarter or 5/6% in an year. However, it is to be noted that deep global market stress can cause Rupee to breach the band temporarily.

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