EXECUTIVE SUMMARY

  • Could the Fed start to normalize its monetary policy earlier than expected? With the USD1.9trn fiscal stimulus package and a new USD2.3trn infrastructure program, we have raised our US GDP growth forecasts to +5.3% in 2021 and +3.8% in 2022. As a consequence, tightening labor market conditions along with higher commodity prices should also lift consumer price inflation to 2.5% in 2021 and 2% in 2022. But we continue to believe that the US Fed will only consider tapering its bond purchases starting in H2 2022 and increasing the Fed Funds Target rate only from H2 2023 onward. And because monetary tightening in the US will certainly generate financial pressures worldwide, we think that the Fed will communicate on its future moves better than it did in 2013, when its announcements surprised markets and caused the taper tantrum. Yet, there is a risk that the Fed may be tempted to normalize its monetary policy earlier, and perhaps again surprise markets due to miscommunication, so Emerging Markets (EMs) may be faced with another potential taper tantrum. Our pattern recognition model confirms that this risk cannot be entirely ruled out.
  • Emerging Market initial conditions are more favorable than in 2013, with exceptions. Current account deficits are lower today, credit growth is at more sustainable levels and we expect inflation to remain under control, by and large. EM currencies are likely to remain volatile but we do not forecast a broad-based repeat of the substantial depreciations experienced in 2013-2014, also because real effective exchange rates are currently less strained as currencies already took large hits in 2020. Moreover, monetary policy is currently ultra-loose in many EMs and it should remain accommodative overall in the near future even though a moderate tightening is likely in those countries where inflation exceeds the central banks’ target ranges. Increases in inflation expectations could put pressure on central banks as the need of adapting the monetary policy clashes with the need to support the Covid-19 recovery.
  • However, external financing requirements and the steady rise in sovereign debt reveal some weak spots. In six countries, the external debt payments falling due in the next 12 months significantly exceed the level of official foreign exchange reserves (Turkey, Argentina, Ukraine, South Africa, Romania, Chile). Moreover, the steady rise in sovereign debt over the past decade poses a significant risk, in particular for those EMs where the share of non-residents’ holdings of public debt has increased over the last seven years.
  • Overall we identify seven EMs particularly vulnerable to the eventual Fed tapering, especially if it is not well communicated, the TUCKANS: Turkey, Ukraine, Chile, Kenya, Argentina, Nigeria, South Africa. A stabilization of the money flows after a complicated 2020 would be crucial, but a pattern of relatively steady inflows into EMs is not yet visible, at least not in a generalized way.
  • EMs, in particular some of the TUCKANS, are already experiencing generalized rises in the interest rates of their local currency bonds. In the short term, this is a sign of upcoming volatility. If sustained, it could pose severe threats to debt sustainability, which was already an issue for some of the countries before. However, this spike could be at least partially a consequence of high growth expectations, which would make it less risky than one solely based on US tapering. 
The interdependence of financial markets, and the predominant position of the US and the USD, make the rest of the world – especially Emerging Markets (EMs) – sensitive to any financial event that takes place in the US, not to mention any changes in the Federal Reserve’s monetary policy. This was last seen in 2013, when just the announcement of future tapering by the Fed governor unchained a generalized spike in US sovereign yields, the appreciation of the USD and capital outflows from fragile EMs.
 
Taking into account President Joe Biden’s USD1.9trn fiscal package and the USD2.3trn infrastructure investment plan, we now expect US GDP to grow by +5.3% y/y in 2021 and +3.8% y/y in 2022, with risks tilted on the upside . As a result, the level of slack of the US job market in particular will diminish more rapidly than expected before (full employment end-2022). We expect the US unemployment rate to hit 4.3% at the end of 2022 compared with 6.2% in February 2021. Fiscal incentives to increase the minimum wage (we integrate a scenario leading us to USD11 per hour by end-2022 compared with USD7.25 today) will add further inflationary pressures alongside the rapid diminution of the US job market’s degree of slack. As a result of these upcoming tightening job market conditions and the positive pass-through of recent energy and commodity prices (the impacts of which are already visible at the level of input prices), we have revised on the upside our US CPI inflation scenario, with 2.5% y/y expected in 2021, 2% in 2022 and 2.1% y/y in 2023. The two-year average CPI yearly increase will reach 2% y/y in early H2 2022 instead of late H2 2022 in our previous scenario.
 

Our Fed reaction function, estimated in function of the spread of inflation between observed data and the target of 2%, and in function of the NAIRU gap, confirms that the US central bank could be tempted to normalize monetary policy much earlier. However, we continue to think that the Fed will only consider tapering starting in H2 2022 and increasing the Fed Funds Target rate only from H2 2023 onward. The proximity between the Funds target rate and the natural rate of interest rate tells us that the current stance of the US monetary policy can be deemed as being only moderately accommodative in the current circumstances. In this case, the Fed will have the luxury to wait and see before really envisaging a normalization in its monetary policy. But despite this forecast, and due to the message conveyed by the mechanical approach of the Fed’s reaction function, episodes of stress and volatility will be visible if the market considers at one point that the Fed is behind the curve. In such circumstances, we need to anticipate the consequences of another potential taper tantrum.
 
Figures 1 and 2: Job market conditions in the US

Figures 1 and 2: Job market conditions in the US
Sources: National statistics, IMF, Allianz Research forecasts
Figure 3: Fed’s theoretical reaction function
Figure 3: Fed’s theoretical reaction function
Sources: National statistics, IMF, Allianz Research forecasts
Figure 4: Fed Funds target rate (%)
Figure 4: Fed Funds target rate (%)
Sources: National statistics, IMF, Allianz Research

What do the markets tell us about the proximity to a taper tantrum-like situation?

One year after Covid-19 shook up the financial markets, the waters are calmer but volatility and risks remain, translating into some market movements, including in the US yield curve and commodities markets , both of which EMs are very sensitive to. In order to analyze the global situation of financial markets, and how close we are to the taper tantrum situation seen in 2013, we use a pattern recognition framework to identify whether there are similarities between the current situation and our pattern of interest (early 2013).

In our case, we use a very large sample of ETFs – cross asset classes and cross geographies – and measure their relative strength against the MSCI World, our benchmark. By doing that, we do not limit ourselves to a particular market or asset but aim to capture the general trend. After comparing today’s strength with the weekly positioning since late 2008 by ETFs, we aggregate the square of the differences and the results are shown in Figure 5.

These results show that the current situation is more similar to relatively calm moments than to severe crisis-like situations. However, as experienced sailors know, it is important to distinguish real calm from apparent calm. Compared to 2013, the framework of today’s situation is not very different (nor the closest) so some kind of taper tantrum is not something that can be excluded.

Figure 5: Pattern recognition – relative strength of financial indicators against the MSCI World

 Figure 5: Pattern recognition – relative strength of financial indicators against the MSCI World
Sources: Bloomberg, Refinitiv, BofA, Allianz Research