Turkey Moves, Focus Shifts to Fed

The US dollar is little changed against the major currencies, while the emerging market currencies are more mixed, ahead of the FOMC statement later today.    Global equities are higher.  Core bond markets are lower, while Spain and Italian bonds continue to outperform.  

The most important development has been the dramatic rate hike by the central bank of Turkey.  This helped underpin not only Turkish lira, but emerging markets, and risk assets more broadly.  At the end of last week and the very start of this week, many were concerned about a US tapering and China wealth management product failure was to trigger an emerging market crisis.  

While cognizant of these influences, we saw the most acute pressure being largely home grown.  The rate hikes in India and Turkey, amidst signs that large maturity of wealth management products in China this week may not be as disruptive as feared, has helped stabilize the global capital markets.  And we expect the Fed to proceed with the tapering strategy laid out a month.  

 We think that the headlines exaggerated the magnitude of Turkey's move and the thin conditions when the announcement was made aggravated the price swings.  An important point that is missed in much of the coverage is that while rates were hiked between 425 and 550 basis points, the rate at which funding will be done has moved from 7.75% (the previous lending rate, which was the top of the policy corridor) to 10.00% (the new repo rate, the middle of the corridor, up from 4.5%).  Under the "simplified operation framework" the top of the rate corridor (now 12%) is less significant.  

We do not expect this series of rate hikes (Brazil, India, Turkey) to reverse sentiment toward emerging markets as an asset class.  We  do expect investors to be more discriminating in this space.  The US and the IMF/World Bank have urged emerging markets to address their macro economic challenges before the Fed begins tightening (the tapering is understood as the necessary transition period).  Those that do not respond convincingly are more vulnerable and, as we have seen, that could become a contagion for the asset class as whole.  

The other important development today is the ECB's money supply and lending data.  In a word, it remains dismal.  Money supply growth continues to slow from 1.5% in November to 1.0% in December, the slowest pace since late 2010.  The market had expected a small uptick.  The 3-month year-over-year rate, used to smooth out the volatility slowed from 1.6% to 1.3%.  

Credit extension to households and businesses continued to contract at a 2.3% year-over-year pace, unchanged from November.    This conceals some deterioration.  Lending to households fell 0.1%, after a flat November reading and a 0.1% gain in October.  It looks like lending to non-financial businesses is stabilizing.  It was 3% lower in December from a year ago, after a 3.8% decline in November and a 3.7% decline in October.  However, even here there are problems.  Excluding non-financial intermediaries like pensions and insurance companies, lending was 12.2% below a year ago compared with a 9.2% decline in November.  

This may fuel speculation over next week's ECB meeting.  However, the lending figures are not being depressed by the price of money, so an interest rate cut, as some have suggested, seems less likely.  Perhaps one of the most important developments from Davos was Draghi's suggestion that the central bank could (eventually) buy bank bonds backed back loans to households and businesses.  The ECB seems more interested in some sort of funding for lending.  We have often argued that the recovery in the US ABS market was very important to jump starting credit creation in the US and the ECB needs to consider how to do this within its institutional framework and conditions. 

The FOMC statement is the main event of the North American session.  The had been some wavering last week as the financial markets become more volatile.  Some thought the Fed could, well, taper it taper.  To the contrary, we suspect that that could be more destabilizing at this juncture than going ahead with the program outlined last month.  We note that despite the weakness in durable goods orders reported yesterday, many economists continue to look for a 3-handle on tomorrow's first look at Q4 GDP.  Final sales, (GDP excluding inventories) appear to be tracking stronger than in Q3 when the US economy grew at an annualized pace of 4.1%.  

The Fed's economic assessment by note some headwinds at the start of the year, like the poor weather, but dismiss them as likely transitory.  The concern about low inflation is likely to be repeated, but will also likely reiterate that inflation expectations remain anchored. 

We remain struck by the fact that if some one were to advise President Obama and Chairman Bernanke how to ensure that Yellen is a weak successor at the helm of the Fed, four actions come to mind:  1) make it clear, she was not the first choice; 2) have Bernanke announce new actions and issue forward guidance just before stepping down, denying her degrees of freedom of action; 3) nominate a new vice chairman whose experience and stature outshines nearly all central bankers, 4) have Bernanke stay until the very end, even though Yellen was confirmed a few weeks ago.   

This is precisely what has happened.  We suspect there will be a price to be paid for this.  It could be in volatility, in the sense that  the market's confidence in the central bank may be weaker.  And the time that this would be most evident is during times when strong Fed leadership is needed most. 

There are two other central banks that meet.  South Africa is not expected to raise rates and the rand is among the world performing emerging market currencies.  It is off about 1.25% ahead of the SARB announcement.   December CPI was up 5.4% year-over-year.   The repo rate stands at 5.0%.  The Reserve Bank of New Zealand's announcement is early Thursday in Wellington.  While higher rates are expected over the course of the year, many expect it to hold off until March.  A surprise move would likely see a quick sharp move.