The Next Emerging Bubble (and crisis?) Is Underway

Both the US weekend print editions of the Financial Times and Wall Street Journal reported on what I consider to be the nextfinancial bubble and potential global financial crisis. Let’s ask ourselves – what would the source of the next financial crisis be?

  •  Japan, with its massive public debt that might, should the market ever give up on Japan, swallow up government spending with unyielding interest payments (should interest rates need to be hiked to defend the loss of confidencet in the economy)?
  • Europe, with its weakened and twisted euro, now bereft of the stability of Britain, at the hands of the profligate consumer south of Europe stretching away from the conservative and producer norther states? It maybe the bailed-out Italian banks fall?
  • US, with its “exorbitant privilege” of reserve currency status but with huge watches of government debt held by China, decides to dump it in order to drive the dollar to he floor as a step to push the yuan to reserve status?

No, none of these three challenges are going to blow-up any time soon though they are clear risks. They are all slow burners.  But what might just snap enough to cause a global financial crisis that can overwhelm the monetary policy and reserves of the world? I think it’s emerging markets. 
You see, there is a finely balanced investment model that is ticking and it slips and slides every day – trillions of dollars – and right now the shift is back toward investing in emerging markets.

This is how it works: Yield is globally very low. This is due to (mainly) low and near- or negative interest rates. As such, the trillions of dollars in the world that represents currency exchange combined with hedge fund investments move around the globe daily in search of yield. When the US Fed suggests that interest rates will rise in the US, it is clearly a vote of confidence in the US economy and so funds are attracted toward the dollar. This then puts pressure on the dollar (since everyone wants dollars) and so the value increases with respect to other currencies. This then leads to increased export prices thus depressing US exports. 

But where does that money come from that would move toward the US? The answer is from everywhere around the world and specifically wherever the money is most liquid. Guess what, that means emerging markets. Right now the US is signaling to the market that interest rates are not going to rise immediately, so yield is slightly more attractive in emerging markets. Thus, as the reports in the two newspapers show, funds are flowing freely towards them. This puts pressure on those economies much as the same funds would do to the US. They stoke currency valuation, inflation and weaker exports (over time).  But short term they hep fund construction and keep the recycling of dollars and funds around the world.

As you probably noted in the last two years, as the Fed sneezes with respect to changes in interest rates, even hints of changes to interest rates, trillions of dollars move back and forth between the US and EM in the search for the greater yield.  US interest rates will raise and when they do, the yield will shift to the US.  And we are talking of razor thin margins hence the nervousness of the market.
From the FT article:

  • Equity funds saw inflows of $5.1bn during week ending August 17, the seventh straight week of inflows, according to data from EPFR
  • Over the same seven weeks, a record $20bn was invested in emerging market bonds, with investors taking money out of US and European bonds in favor of the riskier assets

From the WSJ article:

  • The Bank for International Settlements warned Thursday that a corporate-debt binge for emerging-market countries that starts in 2010 is starting to come due now. Between this year and 2018, repayments will total $340bn, it’s estimates show, which is 40% more than during the past three years

Thus the global system of equity and currency trade and investments are finely balanced. Should the dollar suddenly look more attractive, and funds then flow towards the US, at the exact same time as emerging markets need to recycle their debt, there will be a big problem. Emerging markets will have to jack rates up in an attempt to strengthen their currencies which could choke their own growth, thus reducing the markets confidence in them, and so a spiral takes shape – downward. If EM have to jack up interest rates, the US may have to reciprocate. Either way the balance is finely tuned and the great weight of funds will flip-flop between EM and the world supremely quickly. That will create huge complexity and volatility.

Hang on, everyone!

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