The Taper Might Give Investors A 'Bubble Bath'

by: Michael Blair

It does not look all that dangerous! So why are emerging markets so afraid of the dreaded "Taper".

When central banks attempt to distort markets they almost always succeed. The vaunted Quantitative Easing ("QE") program drove fast money into the higher yields of emerging markets with lovely terms (name your currency) carry trade. Such a simply idea - borrow money at very low rates in the United States and invest it at much higher rates abroad.

QE started in 2009. It was intended to drive up prices for financial assets while driving down short term interest rates. The U.S. QE program was nicely summarized in one chart by Goldman Sachs.

The U.S. was not alone in QE. Other central banks jumped on the bandwagon. Short term rates fell sharply as a result.

With little in the way of return at home, money flowed out of the United States by way of Foreign Direct Investment ("FDI") abroad while less money came into the United States, opening a wide gap in respective FDI following 2008.

With the end of QE in sight, the monies invested abroad have been on vacation long enough and want to come home. But the airport is crowded and investors are jostling for a seat on the plane, driving down the currencies that seemed so attractive in the travel brochure only a few years ago.

Indonesia, South Africa, Brazil, India and Turkey (called the "Fragile Five") are in the vanguard of the currency slide.

Argentina is chaos. Venezuela is looking grim. The Phillipine peso just hit a 4-year low. Talking heads on CNBC are asking whether emerging markets are on the brink of another crisis.

I don't think so. I think they are well past the brink.

The net result is a flight to the U.S. dollar.

The flight to U.S. dollars will very likely trigger successive currency crises in the emerging markets as the hot money attracted by their higher rates flees their falling exchange rates. These moves will no doubt continue to spur civil unrest, labor disruptions, losses on emerging market fixed income paper and possibly bank failures in the affected regions. The watch word is "contagion".

Greece caused a lot of headaches not that long ago. The emerging markets are a lot bigger than Greece. These problems will not go away quickly nor easily.

In the near term, a higher dollar will benefit those who source abroad and will add to deflationary pressures which might persuade the Fed to continue QE postponing the day of reckoning and deepening the problem that will ultimately have to be faced. Or, maybe the Fed will continue its Taper and let the chips fall.

Try to make sure the chips that fall are not yours.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.