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Market mayhem: Last week and after

June 16, 2006 10:25 IST

Elvis has finally left the building. The regime of easy money that propped up asset markets across the globe came to a decisive end last week as central bankers from Mumbai to Frankfurt raised interest rates.

The Turkish central bank, incidentally, hiked borrowing costs for the first time in five years. The impetus came from the US central bank chairman, Ben Bernanke, who asserted that despite some of the weak readings for some of the macroeconomic indicators (like employment and housing prices), the threat of inflation has not waned.

Thus, more hikes in the benchmark Fed funds rate seem imminent going forward. This put paid to the widely held expectation that the Fed would take a break from its relentless rate-raising spree (it has hiked rates 16 times since June 2004) when the next monetary policy review comes up at the end of this month.

What are the lessons that global financial markets have taken from this flurry of events last week? The obvious learning has been that interest rates are likely to be much higher than what investors and traders had factored into asset prices. Thus, asset values and valuations across the board need to be reviewed once again.

This will take a while as fund managers as asset allocators grapple with the question of what constitutes "fair value" at higher rates of discount. But it is reasonable to assume that prices of a number of asset groups like industrial commodities and emerging market stocks are headed southwards. Indian stock prices are unlikely to be an exception.

The more important takeaway, from my perspective, relates to Chairman Bernanke's style and philosophy of monetary management. His statements last week (and earlier) show quite categorically that he is no Greenspan clone.

Unlike the latter, who couched his comments on the economy and markets in strangely eloquent gobbledygook, his successor is a straight talker. Speaking at a bankers' conference on June 5, the new Fed chairman made no bones about the fact that though there were signs of an economic slowdown, the sustained rise in core inflation was "an unwelcome development" and warranted policy action. The bottom line was quite clear - even if US growth were to moderate, interest increases would continue as long as price pressures are alive.

Traders are not entirely happy with this increased transparency. Greenspan's mystical mutterings, however incomprehensible, often had a soothing effect on the market as different participants interpreted his statements in the manner that suited them the best. Given this precedent, Bernanke's cut-and-dried style and his clear enunciation of the problem at hand struck a somewhat jarring note.

Besides, Greenspan was known to have a soft spot for financial markets. The phrase "Greenspan put" was coined during his tenure and referred to the faith that market players had developed that in his tenure, the Fed would not let asset prices slip below a certain level.

In fact, one of the criticisms of his tenure was the fact that he allowed his weakness for the markets to get in the way of tougher policy decisions. Bernanke appears to be more in the classical central banker mould, focusing primarily on inflation management and letting markets find their own level. In fact, one could argue that Bernanke's background as a pedigreed academic economist is visible in his policy stance.

By allowing the US economy to cool off in response to continuous rate hikes, he will also address the structural problems of the US that economists keep warning us about - its massive trade deficit and the yawning gap between savings and investment. This, no doubt, will be positive for the US in the long term but in the short term, it is likely to hurt some of the asset markets.

Last week's events also suggest that monetary policymakers across economies will essentially follow the Fed's lead. This is particularly true of emerging markets that face the risk of capital exodus.

In a situation where global capital seeks safe havens and liquidity is on the wane, no central banker would want to be seen stepping out of line. More than the need to contain domestic inflation, the compulsion of protecting exchange rates will drive emerging market monetary central bankers to keep their fingers firmly on the "raise" button. In short, if Bernanke continues to hike "signal" rates, so will Dr Reddy.

Let me attempt to paint a possible scenario for the year as it pans out. In the short term, markets that had run up on the back of leveraged investments will be hit as the cost of funds rises.

Emerging market equities and industrial commodities are the first examples that come to mind. The search for a safe haven will see large flows into US treasuries and European bonds and despite the hike in policy rates, long-term interest rates in these markets could actually come down, a phenomenon known as yield curve inversion.

Emerging markets won't be so lucky and interest rates across tenors are likely to go up. The dollar will, this period, inch up against most currencies propped up by capital inflow.

In the medium term, as investors become more sanguine about a slowdown in the US, they will seek higher returns elsewhere. My guess is that this will happen by the end of the year.

As the US data show, the dollar will lose in value against other currencies, including the rupee. The concerns about the bloated current account deficit will resurface and add to the momentum of the fall.

The search for higher returns will most likely lead to Europe and Japan, which have shown palpable signs of recovery, and also to some emerging markets.

If, indeed, the rupee begins to rise and Indian company earnings hold up, there could be a revival in the stock markets.

However, in an environment where the world's largest economy is slowing down and liquidity tight, it is unlikely that we will see the heady climb that we saw last year.

The author is chief economist, ABN Amro. The views here are personal

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