Explain the connection between the Fed taper and emerging markets/foreign currencies

There have been big losses in the stock market over the past few days. The narrative I’ve seen goes something along the lines of: the Fed is scaling back its bond buying program, which caused a loss of value in foreign currencies (eg Argentina’s and Turkey’s) and emerging market growth, which is causing a hit to global markets. Here’s a WSJ cite; here’s a Bloomerg cite.

A lot of people predicted stock-market losses as a result of ending the Fed’s stimulus program, and it looks like that is happening. But I don’t understand the connection between the Fed and the Turkish Lira, the Argentinian Peso, or the performance of emerging markets in general. I can believe that it is happening, but I don’t understand the mechanism behind why. If some smart 'doper wouldn’t mind explaining this, I’d appreciate it.

QE3: Fed buys bonds, pushing up bond prices and pushing down bond yields (those last 2 are equivalent). US investors, faced with low US returns, look abroad, bidding up prices of stocks in, say, the Peruvian stock exchange.

Now reverse that. Fed buys fewer bonds. Fewer investors interested in Peruvian stocks. Anticipating this, the Peruvian stock market declines.

Mind you, I’m not saying that’s what happened. Daily stories about the stock market are notorious for dressing up speculation and post-hoc reasoning in an authoritative costume.

So, baked into all this is a rather confident prediction that bond yields are going to rise? And, could they change by more than even 1 or 2%? Just a small change in bond yields is enough motivation to yoink enough funds out of foreign markets to tank them?

It seems amazing that US treasury bond yields have such a big influence. What do you think I’m not getting if that is so surprising to me?

Think of treasuries as the vanilla asset. Everything else is riskier in some way - corporate bonds, US stocks, whatever (assuming we’re discussing a US citizen). So moving treasury rates can have all manner of indirect effects.

The other aspect is that when the Fed buys treasuries it adds to funds in the banking system (reserves, in the parlance). Such funds find their way to other sorts of assets. I don’t like to think in this way to tell you the truth - I prefer to think in terms of prices (interest rates) rather than quantities (supply of reserves) - but it’s another way of framing the problem.

Duration. A 1% to 2% change in 30 year yields will have a much larger effect on the price of those bonds. If yields rise by 2%, the bond price could drop by 25% or more. More details: http://www.finra.org/investors/protectyourself/investoralerts/bonds/p204318

Bonds with shorter maturity, tend to have lower duration. Example. That Vanguard fund has an average maturity of 24 years and a duration of 14 years. So if yields rise by 1%, the price of the fund would drop by about 14%.


So… why is the market moving now? The taper is last month’s news after all. Again, I’m explaining the logic of the argument: I’m not endorsing it. I’ve read of developments in China as well over the past few days (headlines only). They might matter more. Or not.

Ok, here’s another mechanism. Let’s consider 2 currencies call them US dollars and Japanese Yen. Each country trades goods (US Wheat, Japanese televisions) and assets (US treasuries, Toyota stock). But the market for currency has to clear - if Japan is selling us more goods than they are buying (a trade deficit), then they must be buying more assets from us than they are selling to us (so they are buying treasuries on net).

Ookay. Now raise US Treasury yields. This makes them more attractive to foreigners. But to obtain those wonderful bonds, they must first buy US dollars - so the dollar strengthens in terms of foreign currencies. Or (equivalently) the Yen weakens. As does the Mexican Peso or whatever, assuming it’s a floating currency and not one that is held fixed by their central bank.

Now throw in expectations of future rates, speculation in the asset markets, and the journalistic necessity of covering every hiccup with overwrought scrutiny and hand wringing.