Mounting uncertainty over the future direction of US fiscal and monetary policy could result in a spike in Treasury yields and large capital outflows from emerging markets, leading economists have warned.
The Dow Jones Industrial Average ended close to an 18-month high at 12,220.59 on Friday, on the back of the Commerce Department’s announcement that US GDP grew at 3.1% during the final quarter of last year, up from the previous 2.8% growth estimate reported last month. There were also positive earnings data.
But despite the euphoria, economists are warning of significant near-term and medium-term risks.
In the near term, the standoff in Congress over the 2011 Budget continues to threaten a temporary US government shutdown – if agreement is not reached by 8 April, when the current stop-gap agreement expires.
Ted Truman, senior fellow at the Peterson Institute and former US assistant Treasury Secretary, told Emerging Markets that there remains a “small but real probability that we could see a short government shutdown”.
Ten-year yields have risen over the past week to 3.46% as of 25 March, but remain at historically low levels. Phil Suttle, chief economist at the Institute of International Finance, does not expect yields to rise, due to worries about the deficit in the short term, although he sees this as an issue over the medium to long term.
“I can’t see a massive sell-off of Treasuries due to credit concerns in the next six months,” he told Emerging Markets.
However, Truman warned that a failure to agree a credible deficit reduction plan in the coming weeks may prompt sharper-than-expected tightening in future.
“If you have a budget deal that produces a sharp improvement in the fiscal position of the government, that would tend to postpone any monetary tightening, but if you get nothing, that might well accelerate monetary tightening,” he said.
The latter scenario could have a major impact on Treasury yields and global capital flows. Most economists expect a rise in Treasury yields in H2, as the second round of quantitative easing (QE2) comes to an end in June and as the Fed moves towards a less accommodative monetary stance.
Truman does not expect a significant increase in yields unless Fed Chairman Ben Bernanke hikes interest rates later this year as well, an event to which he assigns a 30-40% probability, though adding that this would rise should no agreement on the 2011 Budget.
“I don’t think there’ll be a big hike in rates due to the end of QE2, but if the Fed also raises rates, that’s a different issue,” he said.
Larry Kantor, chief economist at Barclays Capital, does not expect a rate rise this year, but warned in his most recent quarterly outlook, published on March 24, that when it happens next year, it will result in a reallocation of assets away from emerging markets, as investors adopt “a more cautious position” on risk.
Kantor added that the extremely accommodative nature of monetary policy in the US and across developed markets in general may exacerbate the risks of a reversal of capital flows when tightening does occur, as investors retreat to safe havens.
Alberto Bernal, head of emerging markets macroeconomic strategy at Bulltick Capital Markets, warns that US tightening could spark capital outflows from Latin America in particular.
“US tightening is a material risk for Latin American economies,” he said. “When it happens, it will generate material depreciations of Latin American currencies and additional investment shifts from emerging markets to developed markets.”