FOMC taper: Bumpy road ahead for emerging markets?

Most Asian markets crack. Rupee under pressure

The US Federal Reserve (US Fed) sprung no surprises at its meeting and decided to taper its bond buying programme as planned.

At the start of next month, the pace of agency MBS purchases will be reduced to $30 billion/month (from $35 billion/month in January) and the pace at which the US Fed purchases longer-term Treasuries will slow down to $35 billion/month (from $40 billion/month). Also as expected, there was no change in forward guidance this month.

“Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee continues to see the improvement in economic activity and labour market conditions over that period as consistent with growing underlying strength in the broader economy,” FOMC (Federal Open Market Committee) said in a statement.

“In light of the cumulative progress toward maximum employment and the improvement in the outlook for labour market conditions, the Committee decided to make a further measured reduction in the pace of its asset purchases,” it added.

With most analysts expecting the US Fed to stay on course as regards the tapering and suggest the central bank is most likely to hike rates in December 2015, investors in equities, currency as well as fixed income markets are apprehensive of the impact of the US Federal Reserve starting to taper their monthly purchases of Treasuries and Mortgage Backed Securities (MBS).

“Our baseline forecast is that the FOMC will decide to end QE3 in December 2014, after tapering by $10bn at each meeting (except for a final $5bn at the December meeting). Of course, if we see a few more weak Employment Reports, the Committee may decide to skip tapering a meeting or two. We expect the first rate hike in December 2015,” said Jan Lambregts, managing director and global head of financial markets research, Rabobank International.

Sharp reaction

Reacting to the development, most Asian markets lost considerable ground on Thursday, with Hang Seng and Jakarta Composite slipping 1.5% and 1.2%, respectively. Straits Times and Shanghai Composite also skidded over 1% each. The worst hit was the Nikkei 225 index that shed over 3% in trade.

Indian markets also opened weak with the S&P BSE Sensex and the CNX Nifty slipping 0.9% each to 20,454 and 6,064 levels, respectively.

The concern is particularly high for Emerging Market (EM) currencies, which, it is believed, will be particularly impacted by higher US rates. Among these, it is feared the ones with highest Current Account Deficits (CAD) will be most impacted by the sudden slowdown in capital flows.

South Korean won forwards slid 0.7%, while Malaysian ringgit and Thai baht weakened 0.2% in trade on Thursday.

What about India?

Equally, the two economies hit hardest during the first taper tantrum – India and Indonesia – are better placed now. India’s external financing needs in particular have shrunk substantially, while in both economies, new leadership at their respective central banks has quietly gone about restoring policy discipline.

“Financial variables have also already substantially re-priced. The INR and the IDR are cheaper; government bond yields much higher. Still, substantial risks remain. Volatility across a range of asset classes remains unusually damped courtesy of the Fed’s asset purchases and macro-fundamentals remain brittle in both India and Indonesia,” suggests Richard Iley, chief Asia economist with BNP Paribas.

According to Neelkanth Mishra of Credit Suisse, the general elections in India and developments around the taper are the two that are on top of investors' minds for now. “While both are likely to drive market volatility given set expectations around their impact, in our view they have limited near-term impact on the economy and earnings, and the market should revert to the trend soon after these events,” he says.

“Currency volatility and measures adopted by the Reserve Bank of India to curb it, muted earnings expectations and fears that the US Federal Reserve was about to wind down its quantitative easing dominated market moves in 2013. Going ahead, basis the historical average of 12 month-forward price earnings multiples of about 14.2x, Indian equities could rise to 7,100 Nifty levels,” points out Gary Dugan, chief investment officer (CIO) for Asia and Middle East, RBS Wealth Division.

As regards the currency markets, he believes that initial part of 2014 may witness further tightening of liquidity conditions due to seasonal currency leakage and amid strained government finances. Further, given that the US has started to taper quantitative easing (QE), the RBI may have to intervene in currency markets to stabilise the markets, he says.