This unexpectedly sharp drop in the unemployment rate has not only strengthened the Fed's hand in winding down the quantitative easing (QE) programme further but has led some analysts to believe that it might also reconsider its decision to raise rates. This might be initially reflected in its forward guidance that could become much more vague in the future than in the past, where the Fed had taken a no-nonsense approach to holding rates. If the markets were to interpret this as a harbinger of an interest rate hike before the middle of 2015, the dollar would gain at the cost of a number of assets, including emerging market bonds, currencies and commodities. On the other hand if a vaguer, more qualitative guidance coupled with the interest rate and inflation forecasts it provides suggests that the Fed will stick to its promise, the markets could rest easy.
There are, of course, a number of arguments against the Fed moving on the policy rate front earlier than anticipated. Recent data on manufacturing, retail sales and the housing market have been weak (however, some of this weakness could be due to unseasonal weather and does not necessarily reflect a reversal in trend). Inflation seems anchored below two per cent and inflationary expectations measured from treasury yields remain low. Then there is the entire issue of the "participation" rate that might have fallen as unemployed workers felt too discouraged to register for work. They could start returning to the official "labour force" and swell the unemployment figures again.
I now turn to the cloud of uncertainty that hangs over China. Its economic activity indices have been hitting multi-month lows in January and early February, suggesting that the government's plan of reining in credit and a crackdown on its shadow banking system has started to hurt. There is also evidence to suggest that the credit contraction has affected smaller and private enterprises more than the state-owned heavyweights. The former depend more on the shadow banking system and the informal sector for their funding needs, and rates have really spiked there. This has started to pull headline gross domestic product growth and employment growth down and has encouraged China bears to pare their forecasts for growth (I have noticed medium-term forecasts of as low as four to five per cent) and predict severe stress for sectors such as housing and banking.
The issue that financial markets need to grapple with regarding China is whether the government and central bank will watch the decline in growth passively and stay on the path of structural change or whether they would resort to a short-term "cyclical" course correction and start working their money machines again. The Chinese central bank has infused liquidity into the system and forecasts of a cut in the reserve ratio have started doing the rounds. And if indeed the Chinese authorities were seen trying to revive growth prospects, it could give emerging market assets, commodities and "China-plays" like the Australian dollar a fillip.
The funny thing is that despite the jitters over China, commodity prices have been holding up. The CRB all-commodities index has actually gained by about three per cent since October 2013, despite the winding down of QE and increased concerns over China. I am yet to find a rational explanation for this. It could be that commodity traders are betting heavily on a revival in the western economies that would offset the deceleration in China. Else, they could be far more optimistic on China's prospects than other asset markets and believe that the destruction in the demand for commodities predicated on China's slowdown is overblown. The third possibility is that these markets have got things completely wrong and a sharp correction in prices is around the corner.
Emerging markets are going through a strange period in which investors are looking past broad labels and looking at the merits and future of each economy instead of looking for homogenising characteristics. Movements in currencies reflect this "disaggregation" the best even if one were to focus on currencies that trade on the back of current account deficits. The Brazilian real and the rupee have remained remarkably resilient while the Turkish lira and South African rand have fallen. Thus, the notion of an across-the-board pro- or anti-emerging market trade is losing currency. Investors are going more bottom-up rather top-down when it comes to this pack. Thus, it is possible that if India's election outcome is favourable it could gain rather than being beaten up even if the general sentiment is positive towards the dollar.
The final conundrum relates to Europe. Will it ultimately have to fight the deflationary spiral looming over its economy through another round of liquidity easing and rate reduction? Could the euro emerge as a funding currency that fuels "carry-trades" and could its exchange rate consequently tumble? Well, watch this space.
The writer is with HDFC Bank.
These views are personal