DoubleLine White Paper: The Fed, Taper, EM
Many risk and safe-haven investors alike opened 2014 with the opinion that the U.S. would be the main driver of economic growth while the Federal Reserve mechanically dialed back its monthly bond purchase program. The consensus posture of such investors was to be short U.S. Treasuries and emerging market currencies (EM FX). However, recent economic data showing weakness in the U.S. have contradicted that outlook and triggered some repricing across asset classes. The previously close relationship of dollar/EM FX relative to the 10-year Treasury broke down, as demand for safe-havens increased while EM FX remained weak. One of the key questions at this point is whether these repricings reflect transitory economic weakness or presage a loss of momentum in the economic recovery?
In the spring of 2013, the Federal Reserve announced its intention to start tapering the pace of its monthly asset purchase program by the end of that year. However, a big asterisk followed this guidance: *data permitting. Shortly thereafter, the U.S. economic readings came in consistent with a self-sustaining recovery. It seemed as though the data would permit. In unison, both U.S. Treasuries and EM assets, especially EM currencies, sold off for different if related reasons. On the one hand, Treasuries sold off as the market took the “tapering” rhetoric as a signal that the Fed was moving toward tightening monetary policy, including ultimately an end to from Zero Interest Rate Policy (ZIRP). Investors dramatically reduced portfolio duration. On the other hand, EM FX
tanked as higher interest rates in the US caused an unwind of carry trades. (As seen in the USD/EM FX Index¹ in Exhibit 1.) EM countries that rely heavily on external financing suffered massive outflows as foreign investors repatriated capital. The Fragile Five (Brazil, South Africa, Turkey, Indonesia and India) became ground zero in the EM sell-off.
The sell-off in both Treasuries and EM FX paused as then-Fed Chairman Ben Bernanke on July 17, 2013 reaffirmed the Fed’s commitment to keep key policy rates near zero until the economy reached escape velocity. Furthermore, at the end of the third quarter, economic data started to soften amid growing political uncertainty stemming from the U.S. debt ceiling standoff. Investor concerns were relieved when the Fed surprised the market and abstained from tapering at the September meeting of the Federal Open Market Committee (FOMC). In our view, Fed officials were caught off guard by the extent of the mid-year sell-off, triggered by Bernanke’s own messaging, and beat a retreat to forestall a further rise in interest rates.