A New Era of Rising Financing Costs

Discussions on when the Federal Reserve is likely to reduce its bond buying program have reached fever pitch, with analysts and bond fund managers divided on both the timing and the impact the Fed's "tapering" action could have.

The End of Fed QE in Sight?

Societe Generale analysts have thrown their hat in the ring with a bold prediction. They expect the Fed to taper quantitative easing (QE) in the autumn of this year and totally end the program at the turn of the year.

According to the bank, 10-year U.S. Treasury bond yields will hit 3% by spring next year and rise to 5% by 2017. Such a big move in yields that are used as a benchmark across the world has the potential to roil markets.

Bond prices have fallen sharply in recent weeks, pushing yields higher, with the 10-year yield jumping to 2.2% from 1.6% in just six weeks.

However, Ian Spreadbury, strategic bond fund manager at Fidelity, said the turmoil in the markets since Bernanke's "bombshell" on tapering showed how hooked investors were to money printing and that would make it very difficult for the Fed to exit QE.

He said Fidelity's base case is QE will continue with benign inflation: "Our treasury model based on that scenario indicates that yields stay low and potentially go even lower," he said.

"On a two-year view, I would put an 80% chance of QE continuing and possibly increasing. The chances of QE reducing are in the 20-25% range, but clearly that would have an impact on yields. For that to happen I think we need to have a more convincing pick-up in growth."

Spreadbury's alternative scenarios outline the possibility for QE to stop next year, which would send rates to 3%, but he said the negative impact on the economy would be so great that such a scenario was not very likely.

Ian Winship, absolute return bond fund manager at BlackRock, said while he thinks yields on the 10-year Treasury will rise, the Fed will prevent them rising over 3%, as anything over that could "short circuit" the recovery.

"For those that think yields are going a lot higher– that's a big call. If they don't control the yield then that tapers growth more than anything else, and when inflation is barely above 1%, that is a real worry for the Fed," said Winship.

An interest rate increase by the Fed is no longer an entirely hypothetical idea. That potential increase has already inflicted painful losses on bond investors and some hedge funds.

Japan’s Compounding Error

Prime Minister Shinzo Abe's recent announcement of his longer term growth strategy which fell short of expectations, coupled with the disappointment with the BOJ has forced investors to reassess their outlook for the market.

David Kotok, chief investment officer, Cumberland Advisors, agrees, noting that recent havoc in global markets is largely a result of poor communication by both Kuroda and Bernanke. 

"You had a failure to communicate in two central banks at the same time - two of the G-4 botched it up. Bernanke did - he sent a mixed message and stirred a pot. The BOJ has done the same," he said.

However, both central banks will likely try to resolve the instability they have generated in the markets, Kotok said.

Since stunning the markets with unprecedented monetary easing in April, the Bank of Japan has taken a back seat, failing to offer solace to investors that have been rattled by violent swings in the country's bond and equity markets.

According to Kathy Lien, managing director, BK Asset Management, the central bank's "overconfidence" is to blame for the instability plaguing the market.

Lien was referring to the BOJ's meeting this week when the central bank failed to announce additional measures like increasing the maturity on its fixed-rate loan facility to two years from one year.

Knock-on Effect for Emerging Markets

The U.S. Federal Reserve's $85 billion per month bond buying program has fed a steady stream of cash into emerging markets in recent years. But speculation over the potential tapering of the program has led to a spike in risk aversion and heavy outflows from emerging markets in recent times. Stock markets in Thailand, the Philippines and Indonesia have erased considerable gains made this year.

Central banks from India, Brazil, Indonesia and Turkey all intervened in the currency markets this week to shore up their battered currencies, which fell victim to exiting foreign funds. For example, the Indian rupee hit a record low of 58.98 against the U.S. dollar on Tuesday before the Reserve Bank of India intervened.

Geoffrey Yu, forex strategist at UBS said the risk-reward ratio in emerging markets (EM) is disappearing as U.S. rates rise.

“People are buying dollars versus EM full stop, they see this as a structural story, China's growth numbers are going to slow down," he said.

HSBC's forex strategist David Bloom, who had been a dollar “bear” has turned bullish on the greenback.

"The starting point for this EM story was the changing view of the U.S. bond market, meaning what we are witnessing is therefore a USD story and not a EUR one," he added.

A surprise interest rate hike by a 25 basis point from Indonesia came amid one of the worst weeks for emerging markets as heavy capital outflows pounded their equities and currencies. The first hike by an Asian central bank since 2011, following several rate cuts in recent times.

Now analysts anticipate governments to take further action to stem the tide. "We will probably see stronger policy moves. I think the central bank of Indonesia will seriously consider a 50 basis point hike for the main policy rate," said Vishnu Varathan, market economist at Mizuho Corporate Bank in Singapore. "Some degree of capital controls cannot be ruled out at this point," he added.

"More likely than widespread interest rate tightening is verbal intervention in currency markets, backed up by currency intervention - this is already happening in most Asian currencies as central banks attempt to 'smooth volatility'," Robert Prior-Wandesforde, director of Asian Economics Research at Credit Suisse.

Richard Jerram, chief economist at the Bank of Singapore, said the likelihood of policy measures to control outflows would be dependent on whether the country was happy with downward pressure on its currency or not.

Countries with hotter currencies like Thailand and the Philippines would probably be glad to have some downward pressure, he said, while the likes of South Africa, Brazil, Indonesia and India would be less happy with the declines due to their already hefty current account deficits.

Prospects for Capital Raising for Zambia

Zambia issued a $750m Eurobond in April this year at a price of 5.625%. The government has made utterances that it wants to raise $4.5b more to fund capital projects.

It is negotiating with the Africa Development Bank (AfDB) for issuance of local kwacha bonds. Ten year Zambian treasury rates are currently yielding 16.95% in local kwacha on 14^th June.

If yields rise as fast as 10-year US treasuries hitting 3% by spring next year as some suggest, then we might be looking at a near doubling of USD denominated Zambian bonds to 10% next year.

This hypothesis might just put paid to a kwacha bond programme sponsored by AfDB. Risk appetite would just not be there for local currency bond driven away by Fed tapering of QE. A switch into USD may be inevitable if expensive. The Zambian government would be left carrying the currency risk.

Funding growth is about to get a whole lot harder.

David Ryder MA MBA

Consultant. Commentator. Entrepreneur.

www.Viewonzambia.blogspot.com

Main reports from CNBC.com. Conclusions are entire mine.