In today’s Exponential Investor

  • The mothership central bank
  • How Bernanke spooked the markets
  • The four crises of the 1990s
  • US-focused policy risks identifying global weak spots

We begin today’s story with the Ghost of Crises Past.

Instead of wearing a 19th century nightgown and warning of the perils of having too much money, our ghost wears a pinstripe suit and wails “peso” quietly into the void.

You see, central banks are in a race with the economy. Raise rates, or the inflation genie will never go back in the bottle.

But, as I wrote on Tuesday, the problem with this is that increasing rates won’t bring food or energy prices down, though it will certainly spook markets.

The young won’t remember, but the old may have the strangest sense of déjà vu…

The ghost of crises past

The Federal Reserve Bank is the mothership. Throw in the fact that it’s the guardian of the world’s dominant currency and every decision the Fed makes, it makes twice. Once for the US and then again for every other central bank worldwide.

In other words, its actions – while intended for Americans — impact the rest of us, whether we like it or not.  

Take the “Taper Tantrum” of 2013.

Then Fed chair Ben Bernanke announced that he wanted to reduce the size of the Fed’s bond-buying programme “at a future date”, while speculating that rates would need to rise again soon.

No action was taken by Bernanke, however. He didn’t even provide a timeline. He simply told the market what was going to happen in the future, or gave “forward guidance” as central-bank watchers like to call it.  

The US stock market fared well after Bernanke’s statement. The US dollar index (the DXY – a proxy for the value of the US dollar compared to other currencies) rose 6% to a post-crisis high.

Yet problems emerged in smaller countries with shaky balance sheets. This innocuous warning from the Fed saw traders dump emerging-market bonds and move into US Treasuries. The Indian rupee, for example, fell a massive 15% in three months. Other currencies that make up “the fragile five” –South Africa, Brazil, Turkey and Indonesia – all tumbled too.

Sure, these countries were experiencing some economic woes and political instability at the time. But they were hit so hard because of their large US dollar-denominated debt. Traders were worried that rising US interest rates and local currencies falling in value would risk default on the US debt they carried.

Within six months, Bernanke back-peddled, and money started flowing back into emerging markets.

Before the taper tantrum came the tequila crisis

Long before the taper tantrum, a then-insular Fed caused a much bigger emergency. The kind that lays the groundwork for consecutive disasters.

As the US emerged from the early 1990s recession, the market was looking a little hot. Unemployment was down, inflation was on the rise. Very similar to now. Then Fed chair Alan Greenspan was worried inflation was going to get out of hand, and that a bout of 70s-style inflation was on its way.

To prevent this, Greenspan set out to increase the fed funds rate. However, rather than warning the market there were large rate hikes on the way, he just got on with it. Under Greenspan, the Fed funds rose 250 basis points – 2.50% – in just nine months.

No one at the Fed calculated the impact this would have on other countries, and particularly those with US dollar-denominated debt.

Mexico was already in a world of pain from government mismanagement and reckless spending in the 1980s. Much of its funding relied on a little-known contract known as a “tesobond” – essentially a short-term financial product that had to be rolled over frequently – and the value of the peso was pegged to the US dollar. As the Fed hiked, the interest payments on the short-dated debt simply became too much for an economy already in peril.

By the end of 1994, Mexico devalued the peso by 30%. Come 1995, several parties, including the International Monetary Fund (IMF), the Bank of International Settlements (BIS), the US government, and even private banks worked together on a US$50 billion bailout package.

Not long after that, the tequila crisis morphed into the Latin America crisis, which then became the 1997 Asian financial crisis, and we closed the decade with the 1998 Russian ruble crisis.   

All three crises grew from heavy US dollar debt burdens and a collapse in value of local currencies.

History repeats?

There is a “strong historical correlation between sharp interest rate increases in the US and catastrophic economic consequences in the developing world,”wrote economic historian Jamie Martin, an assistant professor Georgetown University.

Aggressive rate hikes out of the Fed won’t just impact the US. The point is that rate rises from the epicentre of the financial system ripple out and risk fracturing its idiosyncrasies. Finding them when those economies are at their weakest can be destabilising for us.

The lessons from the tequila crisis are old, and the taper tantrums are a fresh reminder that any decision the Fed makes, it makes twice.

US dollar-denominated debt is sitting at US$12 trillion today. The Fed has already confirmed that we can expect further 50 basis-point increases.

It’s a case of which emerging market will show the stress from Fed policy decisions, not when.

Until next time,

Shae Russell
Co-editor, Exponential Investor

PS Don’t forget to check out what my co-editor Sam Volkering is working on. Click here to see what he thinks could be the wildest ride of your investing life. But be quick – it’s taking place tomorrow at 2pm. It’s free to attend, you just need to claim your viewing pass.