Risk of QE tapering priced in; see US 10-year at 2.5%: BoA

Claudio Piron, head of emerging Asia foreign exchange and Fixed Income Strategy, Bank of America believes the risk of tapering of quantitative easing (QE) in Q3 has been fully priced in by the markets. He expects the market to rally no matter what the Fed does in Q3.

However, he says that rally will be short-lived and would only provide temporary respite. This is because emerging markets are coming to the conclusion that they have to deal with a world where the Fed will ultimately exit from QE and zero interest rate policies in the next year to one-two years.

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According to him, the US 10-year bond yields will be touch 2.75 percent by the end of Q3 due to anticipation about the Fed tapering in Q3. He also adds that the weakness in the currency market is the best thing that could happen to the emerging markets right now. "The whole beauty of having a floating exchange rate is that it helps in making adjustments and it is better to make the adjustments earlier rather than later," he told CNBC-TV18 in an interview. Below is the verbatim transcript of Claudio Piron's interview on CNBC-TV18 Q: What are the expectations from the US Fed now because emerging market currencies and even equities over the last few days have been appearing quite edgy in the prospect of what might happen there?
A: The way we are catch phrasing this is very much a selling on the rumour and buying on the fact that there is a lot of anticipation about the Fed tapering in Q3. We have based our end Q3 forecast for 2.75 percent on the 10-year yield at the end of Q3 on that risk and now we have overshot that.
The risk of a QE3 tapering in Q3 is now fully priced into the market. So we expect that the Fed may not necessarily taper, we should get a rally in the event that the Fed does taper. It takes away at least some of the uncertainty and we could still get a partial rally. So buy in terms of the fixed income space.
Unfortunately that rally would be short-lived and would only provide temporary respite because emerging markets are coming to the conclusion that we have to deal with a world where the Fed will ultimately exit from QE and zero interest rate policies in the next year to one-two years.

Q: Do you think the gradual withdrawal (of stimulus) over the next few months and quarters raises a risk of serious underperformance for the currency and the equity market for a current account deficit (CAD) nation like India?
A: I would say yes in a three-six months horizon. I would characterise this situation more as serious but not tragic and by that I mean there is a paradox going on.
The situation in India is not critical to the extent that do we have an inflation problem? We have a bit of inflation but we don’t have an inflation problem. Do we have a current account problem? Yes, we do but the currency is moving and adjusting to that.
If you look at the Reserve Bank of India’s (RBI) 6- currency real effective exchange rate (REER) or 36-currency REER, we are at all near historical lows. So the adjustment is happening on the Fx and that will help the current account rebalance towards the end of this year and early next year.
So yes, there is an anxiety that global liquidity will get more constrained but in many ways, the Fx market is not discounting that and by then the strength in liquidity materialises in a year or two, we would have dodged the bullet because the adjustment will have occurred on the exchange rate.
In many ways, the weakness that we are having in the currency is the best thing that could happen to the emerging markets because the whole beauty of having a floating or managed floating exchange rate is that it helps you to make that adjustments and we are making that adjustment now with all things in life it is better to make the adjustments earlier rather than later.

Q: Where does it leave growth in country like India? Do you think it is a probability that many emerging markets including India without this crutch of global capital starts to exhibit much lower average growth over the next many years which in the medium-term can also make this whole asset class less attractive for global investors?
A: Fundamentally the issue is where is that equilibrium level? We have the weakness in currencies, where will we stabilise?
On one hand, we have the normal adjustment in the currency that is helping us to adjust but on the other hand, at which level will we stabilise is also contingent upon the reform. On Wednesday night we will have the latest measures enforced by the policy makers in India and that if you take an anti-market approach curtailing remittances, reducing the ability of Indian multinational investors overseas then the response is more negative that the equilibrium level in terms of the fx has to be for a weaker rupee.
If you take a market based solution as we have seen overnight, let us make adjustments to the maturity account, let us inject some liquidity back to the market and then clearly the response is better. So this is the fundamental issue in terms of what equilibrium rate will do and where will it come down to – do we look for a market based solution, do we look to allowing iron ore exports to be facilitated in reducing the tax or do we revert back to more draconian measures to which clearly the market doesn’t like.