Forex: Currency Brief: Fed holds flat on bond-buying taper
Some analysts have predicted the recent central banks’ interest rates hiking in emerging markets to be a new golden era for the carry trade.
Carry trading is a simple hunt for a higher yield: investors borrow in a currency from a country where interest rates are low or relatively low, such as dollar, yen or Swiss franc. Then they exchange it for a currency where rates are higher and offer a higher return. The rule is: the wider the interest rate differential or gap between borrowing costs and yields, the bigger the profits.
Late on Tuesday, the CBoT increased its main policy rate from 4.5 to 10 per cent and even though investors proved to be disappointed, expecting a much more aggressive move, this decisive action from the central bank could reasonably be perceived to be the start of a new carry trade, pushing USD/TRY and EUR/TRY lower. Since late Tuesday, a bet on the Turkish lira using dollars as a funding currency offers investors 3 per cent in annual returns once Turkey’s inflation rate is factored into the equation.
Market volatility in emerging markets was well-pronounced last week, whereas the sentiment against emerging-market assets has gained fervor yesterday before the broadly-anticipated Fed taper continuation. The slowing growth in these economies and political uncertainty in some of the countries has made investors more skittish, turning the market participants in “panic mode”.
The most striking aspect of Wednesday’s FOMC statement was not that it opted to continue tapering the Fed’s asset purchases, but the complete absence of any reference to that gathering crisis. Remember that many analysts have recently expressed the opinion that the emerging-market turmoil would give the Fed pause. The Fed actually stuck to its goal to maintain price stability and employment. The lack of any reference to the recent market volatility was again lack of interest in the impact on anything but the U.S. economy.
A few years ago, Brazilian Finance Minister Guido Mantega, warned that the Fed was stoking a “currency war” with its aggressive quantitative easing program. Fed officials responded dismissively. The stimulus program unleashed trillions of dollars, creating speculative bubbles in emerging-market currencies, commodities, financial markets and real estate. And, unfortunately, emerging-market central banks were not able at the time – back in 2009 and later on – to respond adequately to curb those bubbles without provoking political and social tensions.
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Exactly the opposite problem materialized following the emergence of the “tapering talk” last year and emerging-market nations now find themselves in a state of the value of their currencies plummeting.
And even though the Fed did not grant any words of sympathy towards the emerging markets, they should at least care about the mess it helped make abroad as it could come back to haunt them. Already we have seen the U.S. stock markets hit by a mild version of contagion and they were down again (all main indices declined on Wednesday as follows: DOW -1.19 per cent, NASDAQ -1.14 per cent, S&P 500 – 1.02 per cent) on yesterday, when the Federal Open Market Committee – the monetary policy setting body –announced its decision to keep interest rates unchanged and maintain the taper by an additional $10 billion decrease in asset purchases.