The presentation outlines the effects of the normalization of monetary policy in the US and further monetary easing by the European Central Bank and the Bank of Japan.
On 29 October, the US Federal Reserve announced that it would complete its tapering program. Moody's expects that, sometime during the first half of 2015, the Fed will gradually start raising the federal funds rate from the current rate of nearly zero.
"We think the Fed's approach is likely to be cautious and measured, which will soften the potential impact on the economy, and in particular, the US banks," says Lucio Vinhas de Souza, a Moody's managing director. The US economy continues to strengthen, with the labor market improving steadily and GDP continuing to grow. Moreover, in the last few years, the US banks have improved their capital positions markedly, giving them larger buffers against unexpected losses even if rates were to increase precipitously or unexpectedly.
All of this places the Fed in a position very different from that of other systemically important monetary authorities in advanced economies, such as the European Central Bank (ECB) and the Bank of Japan, which are moving in an opposite direction, towards further monetary easing. This divergence could result in greater volatility in the currency and stock markets around the world over the short term, as global investors respond by rebalancing their portfolios.
The ECB, faced with downward pricing pressure and weak growth, has announced new easing measures that entail purchasing asset-backed securities and covered bonds that would re-expand its balance sheet.
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Although the scope of the ECB's easing is unknown, monetary policy in the euro area will undoubtedly remain loose over the next few years. At the same time, higher rates in the US could encourage international investors to rebalance their portfolios in favor of US debt. A reversal in capital flows could weaken funding conditions for the euro area sovereigns somewhat, with potentially higher borrowing costs for those countries particularly reliant on foreign investors.
Meanwhile, the Bank of Japan also plans to continue to increase the monetary base through asset purchases, by an annual pace of up to 80 trillion yen, as part of Prime Minister Shinzo Abe's economic initiatives. Japan has even lower yields than Germany, and its gross borrowing requirements are substantially higher than most EU sovereigns.
However, a key difference from the euro area is the home bias in the ownership of debt: Japan-based investors, along with the Bank of Japan, the country's monetary authority, are by far the largest holders of Japanese government bonds.
For the emerging market economies, the effects of a rise in US interest rates will create some headwinds that the looser policies in the euro area and Japan will only partially offset. These emerging economies will have to contend with greater volatility, given that the abundance of global liquidity in search of yield has resulted in a narrowing of risk premiums and a rise in external debt issuance, especially corporate debt.
These countries are therefore vulnerable not only to capital outflows as US yields rise, but also to any erratic financial flows owing to incongruent policy actions by the major central banks. However, as last year's "taper tantrums" demonstrated, country-specific reactions are likely to be temporary and conditional on policies, either existing or expected, and on the existence of buffers.
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