Not out of woods yet, but worst over for EMs: BofA ML

Once EMs start to recognise the fact that the US Fed will withdraw stimulus gradually, stability will return, believes Ethan Harris, BofA Merrill Lynch Global Research.

Emerging market economies, which are fuelled very easily by global monetary policy are not out of the woods yet, but worst seems to be over for them, he told CNBC-TV18 in an interview. "I don't think this is the beginning of a big bear market or a very negative outcome," he added. He sees the Fed slowing down its asset purchases programme by December-end. Further, he cautions that withdrawal of liquidity would be challenging for EMs with high budget deficit or current account deficit. Meanwhile, he expects US bonds to remain rangebound going forward. Also Read: FII outflows not key worry; Sensex can hit 21700: Nomura Below is the edited transcript of Ethan Harris’ interview with CNBC-TV18 Q: The last few days have seen some calm on the global screen. Does it look like some of that poison in terms of selling off is out of the system? A: Fed speakers have been reminding people that tapering will be gradual and is data dependent. We have to see strong growth which has not happened yet. So it's not like they are itching to taper as soon as possible. While the markets are in a very sensitive mood and very sensitive to any particularly sign of strong data, my hope would be that over next few months the markets would calm down a bit and certainly no reversal in this bond sell off because now the markets are a little more realistic about the risks from the Fed. Q: The focal point has been what has been happening with the bond market in the US and the way yields shot up. What have you made of that and what do you expect to see from the bond market now? A: The initial response to Fed's tapering talk was kind of an overreaction in the bond market. The recent stability around 2.5 percent mark for the US 10-year yields makes sense. The markets should remain rangebound in the next few months as we get evidence that the Fed is in no rush. As we go forward, if the Fed is really exiting, we think they are , that it is going to be another step higher in the yields next year. Certainly 10-year yields next year will get above somewhere in 3-3.5 percent range as the Fed finally does execute their exit policy. We have to be cautious on the US bond market. There is no rush here. Now that the markets have had their initial sell off, they will probably stabilise for a while, but the trend is up for bond yields in US. _PAGEBREAK_ Q: How are you approaching emerging markets (EM), what do you foresee happening in that pocket that has already seen quite a bit by way of outflows so far? A: In the near term, one has to continue to be concerned about the risks to the markets because EMs have been fuelled by very easy global monetary policy. There is a withdrawal issue once the markets recognize that the Fed is going to be withdrawing liquidity in the future. But my hope would be that the panic phase is almost over and with the Fed coming out and being very clear that this whole exit process is going to be slow, then some stability returns to the market. We are not out of the woods yet, but I don't think this is the beginning of a big bear market or a very negative outcome. Q: To focus on India what do you expect to see from this market, how does it stake up against the rest of the EM space? A: Countries that have external deficit issues or budget deficit issues will be more vulnerable to withdrawal of global liquidity. For EMs as a whole, my hope will be that once it has recognized that the withdrawal of liquidity is going to be very slow and the Fed is not talking about stopping their policy, they are talking about tapering it sometime later in the year, the markets would settle down a bit. But for countries with budget issues or CAD where they need external funding, the challenges are bigger. Q: What markets at this point are trying to time is what to expect from that Fed tapering program. How soon it kicks in and how much markets have to adjust to it? How many months do you think we have going still for the Fed remain in this easy liquidity mode before things turn around as they have guided? A: The Fed will start to slow down its asset purchases at the very end of this year and then by Q3, perhaps a little bit later, they will stop it entirely. So, liquidity injection will stop. Then the Fed will wait a while, see if economy is doing okay without the liquidity and then they will move to interest rate hikes in 2015. Now for the global markets there is going to be a transition challenge here because you are going to go from a world where there is lots of liquidity to a world where you have a strong US economy because the Fed is not going to do any of this if we don't have a strong US economy. It is a mixed message for the markets. They've gotten used to liquidity driven situation and now we are going to a situation where world’s biggest economy is actually growing at a decent pace which is good for trade and everything else.