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Emerging markets fight the Fed

  • By Richard Barley and Justin Lahart,
  • The Wall Street Journal
  • – 01/29/2014
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As far as the Fed is concerned, if the Turkish economy gets the works, it is nobody's business but the Turks'.

Worries about developing economies are clearly visible. Despite an aggressive overnight rate rise from Turkey, and a subsequent increase by South Africa, emerging-market currencies sold off again Wednesday. The policy actions are aimed at reining in imbalances that have spooked investors. But nerves remain frayed, and the pain is spreading to other countries.

The Federal Reserve is unmoved. At the two-day policy meeting that ended Wednesday, it decided to further reduce monthly bond purchases by $10 billion, to $65 billion, and offered an assessment of the economy that was virtually unchanged from the one given after its December meeting. It was at that meeting that the Fed first began reducing its monthly bond buys.

The implication now is that the Fed sees next to no threat to the U.S. economy from the emerging-markets selloff, which wasn't mentioned in the central bank's postmeeting announcement Wednesday.

That offers cold comfort for investors in emerging markets, many of whom feel the Fed's reduced bond purchases have contributed to the selloff.

And, if anything, the anxiety rippling through markets has made the Fed's task a bit easier. A rush into U.S. Treasurys by investors seeking haven assets has driven down long-term yields.

Turkey is at the center of investors' attention. Having failed to lift rates last week, leading the lira to slide to a low close to 2.40 against the dollar, the Central Bank of Turkey bowed to the inevitable and raised rates.

But it appears not to have delivered a knockout punch. The central bank's interest-rate policy remains complex. While the central bank raised its headline rates by 4.2 to 5.5 percentage points, the effective rise in the rate at which it primarily provides liquidity to the market was 2.8 percentage points. The lira was volatile Wednesday, swinging between 2.16 and 2.30 to the dollar.

Turkey's rate increase should have the right effects over time, narrowing the current-account deficit and cooling inflation, albeit at the cost of economic growth. A contraction in imports will serve to cut the deficit even if it won't address Turkey's heavy external refinancing needs. But all of that will take time to come through.

Meanwhile, markets are clearly fragile, and high volatility won't help. South Africa raised rates to 5.5% from 5%, but the rand continued to weaken against the dollar—even though the rate increase was unexpected.

Not all emerging markets deserve to be painted with the same brush. Worries about Argentina, Ukraine or Venezuela, for example shouldn't bother most investors given those countries' weak links with the global economy. Yet even developing economies with good fundamentals, such as Mexico and Poland, saw their currencies weaken.

In developed markets, the feedback is proving unpleasantly disconcerting for some big-picture and widely held trades. Many expected Treasurys to fall this year as the U.S. economy improved and the Fed exited its bond-buying program. Instead, they have rallied hard, forcing bearish investors to cover short positions. Stocks have failed to follow through on December's surge, in part because of emerging-market worries, and in part because the economic data have been more mixed than many expected.

Even so, the case for decent growth in advanced economies should still hold. That ultimately should be good news for emerging economies, too.

But as the Fed winds down its bond-buying program, the suspicion that its extraordinarily loose policy masked flaws in many emerging markets will set investors' nerves on edge. That could make for a bumpy 2014.

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