The Jackson Hole Economic Policy Symposium attracted the world’s most-watched central banks, and as expected, policymakers kept their cards close to their chests, doing their best to avoid dropping clues about what they’re going to do next as far as quantitative easing goes. Emerging markets investors were especially interested in hearing what European Central Bank President Mario Draghi had to say. Investors and economists alike have been watching QE effects on EM assets, and the ECB’s pace of tapering is one of the last pieces of the puzzle that are missing.
Instead, what may have emerged from the Jackson Hole meeting are signs that a currency war could be looming.
Direct vs. indirect QE effects on EM assets
In a note in late August, Capital Economics Assistant Economist Oliver Jones noted that in the past, QE effects on EM assets have not been good, but this time, he doesn’t expect significant problems to be caused by tapering in the rest of this year or next year.
He also pointed out that most economists talk about the direct effects of quantitative easing, which occur when those who sell bonds to central banks take the proceeds from those sales and reinvest them somewhere else, such as in emerging markets. However, he argues that the problem with this is that direct QE effects on EM assets are few, causing a weak relationship between QE and flows into EM assets. He argues that the reason is because the bigger QE effects on EM assets are indirect.
Varied effects of quantitative easing
Government bond yields in developed markets have fallen because of quantitative easing because investors expect short-term interest rates to stay low for a long time. Another impact is that demand rises relative to supply. The low yields resulting from the effects of QE trigger a repricing of risk, he adds, not only in developed markets but also in emerging ones.
Jones also points out that the spreads of corporate bonds in both the U.S. and emerging markets have fallen in sync with one another and adds that other bonds in emerging markets have “put in a similar performance in the meantime.” Further, he said EM equities’ price to earnings ratios have climbed in recent years, although the P/Es of their peers in developed markets have risen to a greater extent.
Gauging QE effects on EM assets
At the same time, the global economy has been recovering, which he said has also driven the repricing of risk. And in turn, QE has helped drive the recovery of the world’s economy.
“A key factor for EM assets will clearly be how quickly the yields of ‘safe’ assets rise as unconventional policy support is scaled back,” Jones wrote.
He does expect safe asset yields to pick up a bit in the coming years, particularly in the U.S. where he believes interest rates will rise a bit faster than what the markets are discounting at this time. But if central bankers keep treading carefully as they unwind their purchases of assets, he expects a gradual increase in yields to a level that will ultimately still be low compared to the past.
U.S. begins, ECB yet to reveal timing
In the U.S., the Federal Reserve has moved very cautiously in normalizing its balance sheet by trimming reinvestment instead of just selling securities. However, the main reason the world was especially tuned in to what Draghi said at Jackson Hole was because the ECB hadn’t yet signaled any sort of timeline for tapering.
Because of how cautious the Fed has been treading, Treasury yields have pulled back, and Jones expects a similar level of caution at the ECB as it tapers its QE. In fact, he believes the world’s major central banks will keep “adding to their balance sheets in aggregate” until late next year. As far as central banks in emerging markets are concerned, he expects them to keep their policy rates low or possibly even reduce them more over the next year and a half.
Warning about currency war
The U.S. dollar has also weakened this year, although some blame this on the way investors are reacting to what has been a turbulent beginning to President Donald Trump’s time in the Oval Office. According to MarketWatch, the world is sitting on the edge of another currency war because most expected the dollar to be the first of the major currencies to strengthen as the Fed was the first to begin normalizing its QE measures.
The euro has actually been the first to strengthen, despite the fact that the ECB hasn’t set a timeline for tapering its QE. BMO’s European head of currency strategy, Steven Gallo, told MarketWatch in an email that Draghi didn’t even touch the topic of exchange rates because he doesn’t believe the euro’s rise can be broken.