Insight - Fed not falling into EM trap. Not even close

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Rising prices: A woman shops at a supermarket in Manhattan. Data due will likely point to US consumer inflation marching to a fresh four-decade high, thereby tying the Fed’s hands to another 75-basis-point rate hike in July. — Reuters

IN recent months, the Federal Reserve (Fed) has taken a lot of heat from asset managers for letting inflation run out of control and now risking a recession with rapid rate hikes.

The chorus of complaints evolves around its perception in the marketplace.

“If the Fed doesn’t do its job, the market will,” wrote Bill Ackman, founder of Pershing Square Capital Management.

The US Fed “risks slipping further into a no-win interaction that is more familiar to developing countries that lack policy credibility,” Mohamed El-Erian, chief economic adviser at Allianz SE, said in a column for Bloomberg Opinion.

Industry titans have reasons to be annoyed. Data due will likely point to consumer inflation marching to a fresh four-decade high, thereby tying the Fed’s hands to another 75-basis-point rate hike in July.

In just four months, the spread between the 10-year Treasury bond and the two-year note, traditionally a reliable barometer of recession risks, inverted three times.

The International Monetary Fund cut its growth projections for the US economy this year and next.

Broken methods

Meanwhile, some of the time-tested portfolio risk management methods, such as hedging US equity exposure with long-dated Treasuries, are broken.

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Not only did the S&P 500 and Treasuries both deliver negative returns this year, but the correlation between the two asset classes has turned strongly positive.

No doubt, US markets have been weird lately, but everything is relative. Judging by global fund flows, it’s hard to argue investors have lost faith in the Fed.

Rather, developing economies have taken the brunt of the blow.

Investors pulled over US$50bil (RM221.7bil) from emerging markets’ (EMs) bond funds this year, the most severe in at least 17 years.

The redemption on US bond funds, by comparison, has remained fairly tame; sovereign debt even saw inflows, despite losing 7.5% year-to-date.

This is because the Fed is blessed with a currency that is going in the right direction. A strong dollar, which is necessary to tame domestic inflation, keeps portfolio money from fleeing US assets.

Singular focus

EMs, on the other hand, don’t have such luxury. Central bankers there are trapped in a singular focus on inflation, responding more aggressively than expected, and still falling short of keeping up with the dollar.

Their currency weakness, in turn, feeds into domestic price increases in everyday products from wheat to natural gas.

Case in point, Hungary surprised with a massive 185-basis-point rate hike to 7.75% in late June, the biggest rate move since 2008.