The monetary tightening is indeed happening. And it is happening in the two biggest economies in the world, the U.S. and China, simultaneously. Let’s remember that the monetary stimulus introduced by the Fed and China was in response to a financial crisis. And, the question was never if, but when, the Fed and China would taper.
In the last few weeks, we have seen clear evidence from both the U.S. and China that the time has come. The Fed was clear yesterday in noting that the U.S. economy is getting stronger and that it is planning to taper off quantitative easing. There is also clear evidence that the Chinese resolve to tighten is finally happening. Shanghai interbank offer rates, also known as Shibor, have shot up, indicating a short-term liquidity squeeze. The significance of this increase is not the magnitude of the rise in interbank rates, but the duration of the rise. Why? Because the People’s Bank of China (“PBOC”) has had days, indeed weeks now, to inject liquidity in the interbank market. The prolonged rate increase indicates not a lack of ability, but lack of willingness to do so. This to me is a telltale sign that the PBOC is finally serious in its resolve to tighten.
So what does this all mean to Asia’s credit, currency and interest rates?
First, while yields have come off their historical lows in the U.S. and Asia, there is substantially more room for rates to continue to rise.
Second, in terms of credit spreads, we have seen investment grade and high yield spreads widen. We believe that spreads will have some room to widen given a repricing of risk across the globe. However, credit spreads are unlikely to spike as long as default rates stay low. Global high yield rates are still hovering around 3%, with recovery rates better than average. As the availability of capital falls, increasing the cost of capital, this would be negative. However, if U.S. growth is indeed solid, this should eventually have a positive spillover into higher cashflows for global companies.
Finally, rising yields and a solid U.S. recovery bodes well for the U.S. dollar. As such, we expect local Asian currencies will underperform the U.S. dollar in the near term. This is especially true for fiscal and current account deficit countries. However, the silver lining is that it is also precisely tough times like these that push governments to take on tough reforms. Indonesia comes to mind. This week, the country’s parliament passed a controversial fuel price hike. While this will likely increase inflation and inflation expectations in the near term, the long-term positive effects far outweigh the negative. Removal of the subsidies frees up much needed funds for other sectors more critical for future growth such as infrastructure and education. This serves as a reminder that crisis begets change, and it is precisely these seeds for positive change that we hope will blossom in the long term.
© Matthews Asia