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Yellen shows deft hand in Asian diplomacy

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Barron's Asia

Move over John Kerry, and make room for Janet Yellen.

An odd thought, perhaps, given that diplomacy is U.S. Secretary of State Kerry’s thing, while Fed Chair Yellen tends to monetary policy. But a unique feature of today’s fragile and interconnected markets is how geopolitical fallout, particularly in Asia, will increasingly force the Federal Reserve to scale back its tightening ambitions.

“The U.S. central bank is very much carrying out actions to help soften problems that would usually be the role of the State Department,” Boston bond-market veteran Dan Fuss said in Tokyo. While the Fed’s mandate is domestic stability, it faces unprecedented considerations about destabilizing far-away nations Washington hopes to keep stable. “That’s a huge concern,” Fuss said. And a fast growing one.

This observation is intriguing partly because of who’s making it. Fuss is vice chairman of Loomis Sayles, with about $230 billion under management, and after 60 years in the business, he’s one of the global debt arena’s wise old men. When Fuss looks at the world today — China’s slowdown, that wasted opportunity called Abenomics, a possible Donald Trump presidency — he’s quick to admit he’s “never seen anything like this” and that we live in a disorienting time when “there are no real experts” to offer guidance.

And few realms are more perplexing than the art of central banking, one that seemed straightforward just five years ago. The Bank of Japan, European Central Bank and other powers, Fuss noted, are stretching their mandates — all are effectively using monetary policy to enable expansive fiscal policies. Central bank independence? What’s that? But the Yellen Fed’s balancing act is far more challenging, and not just because of the November presidential election. The Fed, for better or worse, is now the central bank to the world’s central banks, a role once accorded to the Basel-based Bank for International Settlements. That mission creep is the best argument against the Fed hiking rates very much this year.

“The Fed’s biggest concern now is out of its mandate — global considerations,” Fuss said. “They are between one big rock and four hard places.” Make that “five or six hard places,” he added.

The rock, of course, is pressure in Washington to normalize the borrowing environment. Many of the hard places to which Fuss alludes are here in Asia: China, Indonesia, South Korea and a host of other emerging economies where post-2008-crisis borrowing binges and trade imbalances leave markets vulnerable to Fed rate hikes. The risk of toppling Mexico in 1994 or Asia three years later didn’t stop the Alan Greenspan Fed from pursuing its domestic mandate. Tightening global credit markets didn’t keep the Ben Bernanke Fed from withdrawing liquidity in 2006. But that was then.

Today, U.S. financial conditions are certainly among those “hard places” and complicating global dynamics. As Fuss said, ominously, of waning liquidity: “It’s probably going to be the worst quarter in history for a number of the fixed income-oriented hedge funds. A few are already known, but there are some that were wiped out and just wound down.”

Among them: Chicago-based Golub Capital, which is shuttering a $150 million credit-hedge fund betting on distressed debt. In 2015, more hedge funds went bust than the number of newly created ones for the first time since 2009. And 2016? “The market is going, I think, to stay thin,” Fuss said. “Volatility will stay high any time you have a major change like this.”

Make that changes, plural, including the very nature of central banking. “It’s obvious that independent monetary policy does not exist anymore,” said strategist Salman Ahmed of Lombard Odier Investment Managers. “The actions of the Fed, ECB and Bank of Japan are inextricably linked and becoming more politicized given the reliance on monetary policy as the key growth supporting tool. Investors need to be very aware that with continued low and in some instances negative interest rates in place there is a powerful long-term impact on the valuation of all risky asset classes.”

Fuss has been trading crises since the 1950s: America’s fiscal hiccups and stagflation, Fed Chairman Paul Volcker’s anti-inflation crusade in the ’70s and ’80s, Latin America’s crackups, Asia’s 1997 meltdown and Russia’s soon after and Wall Street’s implosion in 2008. He’s made a career of Warren Buffett-like value investing in debt of all kinds — from conventional public bonds to busted-convertible IOUs. And yet today’s world is as bewildering as he’s ever encountered.

Asked when the BOJ might exit its quantitative-easing experiment, Fuss quips: “I mean how is that even possible” when the central bank is cornering bond markets so yields don’t skyrocket? Did the Fed err in raising rates last December? No, Fuss argues, given the overwhelming pressure from bankers unable to attract deposits and politicians worried about a sudden inflation surge. With one 25 basis-point rate move, though, Yellen highlighted the difficulties facing emerging Asia, starting with China.

If any major economy is ill-prepared to live with less global liquidity, it’s Asia’s biggest. Japan, too, which is getting little traction from negative rates. The more the Fed drains from markets, the more BOJ Gov. Haruhiko Kuroda needs to add. Yet further rate moves could destabilize China in unpredictable ways that spill back on the U.S. One risk factor is China’s dollar hoard, which shrank by $100 billion in January alone. Increased selling by the People’s Bank of China could spook world markets and boost U.S. bond yields.

The bigger problem is the loss of the only real economic engine outside the U.S. in recent years. While the 6.5 percent growth Beijing is pledging is low by historical standards, it’s a godsend on a world in which Europe and Japan are walking in place and emerging markets are slowing. But debt is a big and growing Chinese vulnerability.

Take the 23 percent surge in accounts receivable over the past two years to about $590 billion, more than Taiwan’s annual output. According to Bloomberg News, Chinese companies are having the most trouble getting clients to pay bills since 1999, back when Premier Zhu Rongji was closing thousands of state-run companies. It’s another reason to doubt current Premier Li Keqiang’s pledge to curb excesses without huge layoffs. China’s $28 trillion post-Lehman Brothers credit bubble and untold trillions of dollars of local government borrowing mean Yellen must tread more carefully than predecessors Bernanke, Greenspan or Volcker ever had to.

Unofficially, of course. The Fed’s stated mandate is U.S. inflation and employment. But the last thing Beijing wants is to be at the epicenter of the next crisis that causes Kerry and his State Department team sleepless nights. And the last thing Yellen wants is to help topple China or other geopolitical hotspots. That would be undiplomatic, indeed.

William Pesek is executive editor of Barron’s Asia. www.barronsasia.com