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   ARTICLE   |   From Scotsman Guide Residential Edition   |   November 2018

What Happens in Emerging Markets Doesn’t Stay There

Economic woes in nations like Turkey, Iran and Argentina can impact the U.S. housing market

Mortgage originators’ business is seriously affected by interest rates. Rates affect purchase business to some extent and refinance business greatly.

Originators pay attention every day to rate movements. Mortgage rates move in harmony with the yield of the 10-year Treasury note. Yields on Treasury debt and other fixed-income securities typically move with the perception of inflation in the United States. r_2018-11_Lepre_spot

Usually, it is domestic macroeconomic fundamentals that tend to drive U.S. Treasury and mortgage rates. We may be entering a time, however, when Treasury yields and mortgage rates will depend more on what is happening outside the U.S.

The domestic fundamentals in recent years have contained few surprises. What is happening in emerging markets is nothing but surprises. The important point for mortgage originators to note is that, in the near future, there may be a significant flow of money from emerging-market nations to the safety of U.S. Treasurys and mortgage-backed securities.

Failed policies

Why is this monetary trend on the horizon? The simple answer is that many emerging market countries have so seriously mismanaged their monetary policy that they have caused inflation and debasement of the values of their currencies compared to the U.S. dollar and the euro. That has led to social and political instability.

The consequences of this will be serious, and money will likely leave emerging nations and seek the safety of U.S. treasury and mortgage-backed securities debt. To the extent that this happens, we should see lower Treasury and mortgage rates.

The definition of emerging markets is somewhat vague and flexible. It would be easier to enumerate countries regarded as emerging markets: Argentina, Brazil, India, Indonesia, Mexico, Poland, South Africa, South Korea, Turkey, Egypt, Iran, Nigeria, Pakistan, Russia, Saudi Arabia, Taiwan and Thailand.

An increase in investments in and lending to nations and companies in emerging markets occurred after 2008, when central banks in the U.S. and the European Union (EU) dramatically lowered short-term interest rates. Investors needed or wanted larger returns.

Investing in and lending to emerging markets produced much higher returns on investments than investments in the U.S. and the EU. Emerging-market nations have faster growth in gross domestic product than nations with established economies.

They also have a large majority of the world’s population. These were not only return-on-investment decisions, but this also made strategic sense because emerging markets were seen as the greatest source of future demand. These investments and loans were riskier, but were deemed to be offset by higher rewards.

Mismanaged currency

Failed monetary policy results from a nation creating too much currency. The value of a nation’s currency is measured by its value when exchanged for the U.S. dollar or the euro on foreign-exchange markets.

Nations with poorly managed economies often create too much fiat currency. In these cases, the central bank finances government overspending by producing, out of thin air, money that the government cannot get from either tax revenue or borrowing. In essence, bad fiscal policy begets bad monetary policy.

If the supply of a nation’s currency increases, and the foreign-exchange demand stays constant or drops, that nation’s currency will lose value relative to other currencies. This makes imports more expensive and is part of what causes inflation. At present, the best example of monetary policy gone badly is in Venezuela.

To have a sense of where mortgage rates are going in the U.S. in the near
future, pay attention to what is happening with the
economies of Iran, Turkey and Argentina.  ” 

The problem is not merely with central banks. There are two types of money: state money and private money. Central banks produce state money, but commercial banks activate or put into play private money when they make loans.

During the post-2008 recovery, federal regulation coupled with the Basel Accords, which address lender risk, stifled bank lending in the U.S. Conversely, if a government is too loose in its regulation of bank lending, banks can produce too much money as well. This too-rapid expansion of money supply, both by central banks and private banks, results in inflation.

Safe haven

Some emerging-market nations have such serious economic problems, such as Venezuela, that capital starts to seek out safer havens. Some of that will move to U.S. Treasury and mortgage-backed securities debt.

As nations default on debt, and as companies in emerging markets go bankrupt, the contagion can spread. It may infect the EU banking system, for example, which could create counterparty risk and slow down the economy of Europe.

Interestingly, the problems of each emerging nation have somewhat different causes yet certain similarities. Causes include vigorous government spending on infrastructure, which suddenly stops as governments can no longer borrow to support spending; irrational exuberance by banks and other lenders seeking high returns; and business seeking to expand and borrowing so much that they cannot pay it back and wind up going bankrupt.

The likely consequence of this capital flight will be that investments in emerging-market nations will be reduced. Some of the money withdrawn will be re-invested in the U.S. The bulk of bank lending in emerging-market nations has been from European banks. Consequently, the effect on U.S. banks should be small.

Repeating the past

This capital-flight risk is occurring at a time when the Federal Reserve is moving short-term interest rates higher, thus making the U.S. an attractive place to park money departing emerging markets. It is better to get a 2.5 percent return on your money than to take a 10 percent loss on an investment gone bad.

The last time something such as this occurred was the Asian currency crisis of 1997-1998. That situation was similar to the one that appears to be mounting now. Money, both in the form of equity investments and loans, initially flowed into those Asian countries because rates of return were higher than elsewhere.

Trouble started, however, when Thailand — which had previously pegged its currency to the U.S. dollar — dropped the peg and floated its currency. Currency devaluation ensued, and it became difficult for Thailand to service its dollar-denominated debt.

The effects of the Asian currency crisis were dramatic. Indonesian President Suharto resigned. On Oct. 27, 1997, the Dow lost 7.2 percent of its value, and the yield on the 10-year Treasury fell from 6.9 percent in April 1997 to 4.4 percent by October 1998. Those changes in equity and Treasury prices reflected the fact that hot money was running from risky assets to the safety of U.S. Treasury debt.

The U.S. banking system suffered very little damage from the Asian currency crisis. On Christmas Eve 1997, the New York Fed met with the U.S. banks with the largest exposures to South Korean debt and got them to voluntarily commit to roll over their short-term loans to medium-term debt.

The number to pay attention to in emerging markets is the inflation rate. As of this past September, these were some of the out-of-control annual inflation rates, according to the Hanke Inflation Weekly report: Venezuela, 48,072 percent; Iran, 260 percent; Argentina, 122 percent; Sudan, 103 percent; Turkey, 90 percent; and Yemen, 66 percent.

Bad monetary policy can work in the opposite direction. A chilling example that we should never forget is India’s recent decision to remove 86 percent of its currency from circulation — overnight and with-out warning. In order to combat crime, including tax evasion, India eliminated large bills and reduced its money supply. Unlike the U.S., which is a credit card nation, India is a cash nation, and elimination of that much currency seriously jolted the nation’s economy.

Emerging markets also have relatively little transparency in the reporting of data. In the U.S. and EU, investors demand answers and question authority. This leads to relative transparency.

We are seeing economic issues in Europe, China, and Turkey as well as a reduction in willingness to invest in emerging markets. Inflation is high and currencies are becoming useless in Venezuela, Argentina and Iran. All of this could translate into flight-to-quality buying of U.S. Treasurys and mortgage-backed securities debt. While the euro remains strong, the EU has members with weak economies, such as Italy, Portugal, Spain and Greece. How the financially stronger EU nations deal with this emerging problem is largely unknown.

The path ahead

To have a sense of where mortgage rates are going in the U.S. in the near future, pay attention to what is happening with the economies, and particularly the currencies, of Iran, Turkey and Argentina. As the values of these currencies deteriorate on foreign exchanges, it will become more difficult for those nations to service debt.

One number everyone should pay attention to, even after the dust settles, is the exchange rate of the U.S. dollar versus the euro. It is believed by many that a weak dollar stimulates economic growth because it makes exports cheaper, imports more expensive and lowers the trade deficit. That is not the entire case.

While a strong dollar generally increases the trade deficit, it makes businesses more confident about investing and increasing productivity. This investment helps expand gross domestic product — the value of goods and services in the U.S. — to a much larger degree, and those investments are long-lasting.

The extent to which the backflow of money from emerging markets will lower Treasury yields and mortgage rates is unknown, given no one has a good idea of just how troubled some of these foreign economies are. The one certainty is that U.S. Treasury debt remains the world’s safest investment.


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