Uneasy Calm Awaiting Interest Rates Lift-Off – BIS by BIS

The interplay between the shifting prospects for policy normalization in the United States, emerging market (EM) weaknesses and accommodation in other major advanced economies (AEs), drove market developments in the fourth quarter of 2015.

Markets stabilized in October, following the August rout. Fears of a crisis centering on EMs faded as Chinese equity and currency markets – the rout’s epicenter – entered calmer waters. Sentiment improved after policy interventions in EMEs and on expectations of continuing monetary accommodation in AEs, including the United States. Asset markets across the world staged a strong rebound and volatilities fell.

Market sentiment changed following the Federal Open Market Committee’s (FOMC) October meeting and the strong US labour market report in early November. Both events raised the odds of a December interest rates hike in the United States. US bond yields rose and the dollar re-asserted its strength, reflecting expectations that monetary policies will diverge across the major AEs.

Although EME markets suffered a particularly sharp re-pricing, market reactions were short-lived. In the first five days following the US payroll data, equity, bond and foreign exchange markets seemed to replay the mid-2013 “taper tantrum”. But in contrast to the continued deterioration that took place then, markets across the different EM asset classes largely recouped their initial losses by mid-November.

The short-lived market response might suggest that EMEs could ride out the prospect of US monetary tightening. However, less favourable financial market conditions, combined with a weaker macroeconomic outlook and increased sensitivity to US interest rates, heighten the risk of negative spillovers to EMEs once US interest rates do start to rise in the United States. Tighter financial conditions could also accentuate rising financial stability risks in a number of EMEs.

October rebound

Markets bounced back in October after two turbulent months. In August and September, global financial markets saw sharp corrections in response to disappointing news from EMEs and high financial market volatility in China.1 As a result, global equity markets posted their heaviest quarterly losses since 2012 (Graph 1, left-hand panel), while implied volatilities across markets (Graph 1, centre panel) and corporate credit spreads surged.

EMs were hit hard. Equity markets plummeted, and EM currencies took another dive after months of weakness (Graph 1, right-hand panel). Market volatility and currency weakness coincided with an exodus of capital from EMEs (Graph 2, left-hand panel). EPFR reported combined portfolio outflows of more than $45 billion from EM mutual funds in August and September, much larger than during the mid-2013 taper tantrum.

In October, equity markets staged a remarkable recovery, recording their strongest one-month gain in recent years. Market nerves were partly calmed by receding fears over tail risk in China. The improvement was broad-based. European and American stocks recouped nearly all losses experienced in the third quarter, while China’s stocks also made up some lost ground. In tandem, equity market volatility eased.

Other markets also recovered, although not as strongly. Spreads tightened in credit markets, but remained wider than last year. Similarly, exchange rates began to stabilise while bond and exchange rate volatilities fell. In addition, capital returned to EMEs, albeit on a modest scale.

interest rates

interest rates

The market rebound occurred despite few signs of improvement in the macroeconomic backdrop. Except in India, the purchasing managers’ index (PMI) – a leading indicator for economic activity – remained in contractionary territory in October in the major EMEs (Graph 2, centre panel). China recorded its lowest GDP growth rate in the third quarter (6.9% annualised) since the first half of 2009, and industrial production and fixed investment stayed sluggish in October. Brazil and Russia remained deep in recession as political factors added to economic woes.These developments weighed on the outlook in the major AEs, although their PMIs signalled continued expansion.

Sub-par growth expectations in EMEs also put further downward pressure on commodity prices. Oil prices staged a brief rebound in early October, but have since sunk below $50 per barrel (Graph 2, right-hand panel). Base metal prices continued to dip.

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