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Tapering of Quantitative Easing (QE) in the US could act as a brake on global growth, according to QNB Group. Concerns about QE tapering in the US have had a dramatic impact on global exchange rates and interest rates in recent months. Emerging market currencies have weakened and global interest rates have risen significantly, as capital has flown out of emerging market assets. Even before bond purchases by the Federal Reserves are actually scaled back, central banks in Emerging Markets (EM) have been forced to tighten monetary policy, thus reducing growth prospects. QE tapering is also likely to lead to further EM currency weakness. Overall, this tightening of monetary policy is likely to lead to lower EM activity that will act as a break on global growth in the months ahead, according to QNB group.
 
Distress about QE tapering was initiated by comments from the Chairman of the Federal Reserve (Fed), Ben Bernanke, on June 19th when he stated that the pace of bond purchases might be reduced as the US economy was strengthening. Markets reacted strongly to the statement: the S&P 500 stock index fell 4.8% over the next 5 days; the US Dollar appreciated by 620 pips against the Euro during the subsequent 3 weeks; and US 10-year sovereign bond yields rose from 2.19% to a peak of 2.74% on July 5.
 
There were knock-on effects in emerging markets. QE had created surplus liquidity in global financial markets, which was directed towards emerging markets in search of higher yields. This enabled emerging markets to have record low interest rates and an environment generally conducive to higher growth than in advanced economies. Concerns about QE tapering, therefore, prompted investors to withdraw capital from EM to take advantage of higher US bond yields. This led to: a 7.4% drop in the MSCI EM stockmarket index in 5 days; weaker EM currencies (JP Morgan’s EM currency index fell 2.5% in 5 days); and higher sovereign bond yields. In essence, the announcement of QE tapering was a complete shift in the liquidity paradigm that had financed EM growth until then.
 
Global Exchange Rates
(Indices based to 100 on 18th June)
 
Effects Bernanke

Source: Bloomberg
 
EM exchange rates have recovered in July, based on monetary tightening by the respective central banks. The sudden drop in EM exchange rates forced a number of central banks to hike policy interest rates to help support their currencies. Central bank rates have been increased in Brazil, India, Indonesia, and Turkey. More central bank rate hikes can be expected in the near future to encourage greater exchange rate stability. The drain in liquidity from EM and rising long- and short-term interest rates are likely to have a negative impact on growth by restricting capital available for investment and making borrowing more expensive.
 
In July, there has been a fair amount of backtracking by the Federal Reserve to temper concerns about QE tapering. Members of the Fed’s monetary policy committee restated that QE will only be tapered when the economic data is strong enough. On July 11th Bernanke commented that policy would remain accommodative for the foreseeable future and on July 17th he stated that QE would depend on economic data and is not on a preset course. This has helped US government 10-year yields stabilize around their current levels of 2.61%, slightly below July 5th highs. The drop in US interest rates lowered the differential with European rates, leading to a stronger Euro against the US Dollar. The Euro has been further boosted by recent better-than-expected manufacturing data.
 
Market expectations are for the Federal Reserve to begin tapering its bond purchases from USD85bn per month to USD65bn per month following its monetary policy meeting on September 17th-18th. This is likely to lead to higher long-term US sovereign bond yields, driving up the cost of borrowing and acting as a brake on global growth. The announcement of QE tapering will probably lead to further capital flight from EM, weaker currencies and increases in central bank policy interest rates resulting in softer growth. EM have driven global growth since the financial crisis, but with the outlook for EM growth deteriorating and growth in advanced economies expected to remain muted, expectations for global growth are likely to be revised downwards, according to QNB Group. 
 

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