How Quantitative Tightening is Punishing Emerging Markets and Gold


The global synchronized growth story ended on September 2017 when the Federal Reserve announced an end to quantitative easing and an effort to normalize its balance sheet. With divergent Fed policy leading to a stronger dollar, and knock-on effects of that stronger dollar reverberating through emerging and precious metal markets, now is an exciting time for the global macro investor. The following is the situation I expect to continue to play out in global financial markets for the next several quarters—with a target date of Q2 2019. 

The situation is bearish for EM and gold while bullish for the USD and an already overvalued U.S. equity market. This scenario runs counter to the prevailing wisdom of many global macro investors that have run to EM and gold in the face of an overvalued U.S. equity market. If you are in this crowd—there may be more pain to come. Don’t shoot the messenger.

QT as a catalyst to dollar strength

Quantitative easing led to an explosion in the monetary base from $825 billion in 2007 to $2.9 trillion by the end of 2013 and during the heart of the QE program. Quantitative tightening, or allowing the bonds bought during quantitative easing to reach maturity, has the opposite effect. QT shrinks the global supply of dollars. Meanwhile, global demand for dollars remains the same. Global trade is largely conducted in dollars, with 64% of global central bank reserves held in the reserve currency. If a country increases its GDP by 4%, that means it needs 4% more dollars to buy oil, agriculture, base metals, etc. Decreasing supply with increasing demand leads to an increase in the value of the dollar. Until other global central banks hop on the QT train, or until the Federal Reserve tightens us into the next recession, the dollar should continue to strengthen while the EURO, YEN, ADXY, and EM currencies weaken.



EM to go lower

Countries that own dollar denominated debt (all of them) will have to make higher payments as their currencies weaken against the dollar and as interest rates rise in the U.S. Increased debt payments means they will find it harder to fuel growth through additional debt, leading to a slowdown in EM growth. Add global trade wars to the mix and it spells disaster for emerging markets. 

Case in point: Turkey. Turkey has an over-reliance on short-term foreign debt to the tune of $460 billion. The U.S. also placed tariffs on Turkish steel and aluminum due to the incarceration of a U.S. pastor in 2016. The Turkish lira has lost more than 40% of its value against the dollar this year. If the dollar continues to rally, rates continue to increase, and the U.S. continues its trade wars, expect more pain in China, Brazil, Japan, and Europe.

(As a side note, keep a close eye on Spain, France, and Italy, who own a combined $100+ billion of defaulting Turkish debt.)



Gold to go lower, then higher

The price of gold is inversely correlated to the value of the dollar. When the dollar loses value, investors seek to put their dollars in assets that serve as a store of value such as gold, commodities, and *mumbles under breath* bitcoin. While possible for the two to rise simultaneously (such as in the face of political risk), the dynamic is simply not there. I expect gold to rally in the next crisis, especially if it manifests itself in a currency war. Until then, expect gold to continue to fall.



Dollar strength begets dollar strength

As international currencies and stock markets weaken against the dollar and the S & P 500, international investors will flood to the U.S. The dynamic here is self-reinforcing: 1) dollar strength hurts international markets. 2) international investors run to the dollar. 3) dollar strengthens even further against international markets. 



Conclusion

I expect this dynamic to continue for the next 12-24 months. The catalyst for a reversal in this dynamic will likely be the next recession that forces the Federal Reserve to lower rates and increase its balance sheet once again. Until then, look for bargain opportunities in Gold and EM. Buy dollars if you haven’t already, and don’t sell your U.S. equities quite yet. Sell EM currencies and EM markets themselves if you favor a short-term orientation. 

The crisis in Turkey will invariably hurt Europe. The rallying dollar will invariably hurt China, Brazil, India, and other emerging market economies. The global macro investor and tactical asset allocator will reign supreme in the upcoming months. 

Sources:
https://www.nationalreview.com/corner/emerging-economies-dollar-denominated-debt/
https://www.thebalance.com/world-currency-3305931
http://www.atimes.com/could-turkey-trigger-the-next-global-financial-crisis/
https://tradingeconomics.com/united-states/capital-flows

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