Moneycontrol Pro Panorama | The things that keep us honest

The global exchange rate market is a great leveller and disciplinarian when it comes to external sector of countries.

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Markets and policymakers are supposed to keep each other honest and most times they do. If markets step into unwarranted and uncharted territory, policymakers swoop in to discipline them. When policymakers tend to act with a high hand, markets remind them of the boundaries of their power. Sometimes, markets also kick policymakers out of their jobs. Recall UK prime minister Liz Truss’s tumultuous period when she cut taxes that jeopardised British fiscal policy and how the bond market reminded her with surging yields that it cannot be done. Truss bowed out rather unceremoniously from office.

But what happens when one befuddles the other remarkably?

US President Donald Trump’s executive orders and tariffs have left investors wondering which way the economy would go and therefore, what the response from the central bank would be. Globally, foreign exchange, bond and equity markets are having a tough time figuring out the impact.

The US bond market has already grasped the straws of certainties such as tariffs will increase inflation in the US and elsewhere. But the impact of tariffs on US economic growth is unclear and it is difficult to question the resilience of the US economy. History has punished those who have bet against the US. An article in the Financial Times titled ‘Will the bond market rein in Trump?’ captures the confusion among bond investors. The US bond market is at sea whether to worry about inflation or recession.

At the same time, US treasury spending is expected to far exceed its revenue, widening the fiscal deficit as the Trump administration prioritises tax cuts. But since the dollar is the reserve currency, foreign investors have no alternative to the heft of the US treasury bond market when it comes to investment. Ironically, the US treasury note would be a safe haven for investors from the uncertainties that Trump infuses into global markets. Long-term bond yields that climbed after Trump’s election have now receded and don’t seem to be in for another rally. In a way it seems the US bond market is keeping investors in other emerging markets honest by outshining any alternative market. One wonders who will end up disciplining who.

All this means that the dollar’s supremacy continues in the short term and other currencies would continue to be under pressure. The global exchange rate market is a great leveller and disciplinarian when it comes to external sector of countries. When dollars return to US shores, exchange rates would tend to capture this and therefore, central banks would need to step in to instil some discipline. The Reserve Bank of India (RBI) has been disciplining more than before recently and our Chart of the Day captures this here. Of course, this intervention got India the tag of currency manipulator from the US Treasury (which has now been removed), but China and other nations remain on the Treasury’s watchlist. As such, more and more emerging market economies are adopting an active intervention policy.

Meanwhile, the biggest gauge of whether policymakers are doing it right is the equity markets. Stock prices show the mirror day in and day out to companies, not just policymakers. India’s equity valuations are coming to terms with global uncertainty and a rather poor show on earnings by companies back home. That explains the tumble in indices in the recent months. Ananya Roy brings out these points here and warns that the lukewarm earnings outlook would discipline valuations in the coming days.

But sometimes investors need some comeuppance and that is behind the carnage in midcaps and smallcaps. Frothy valuations, pointed out by some investors, are now beginning to fall off in this segment with stock prices heading towards more realistic levels. The story of the US stock market is so far different, though. US exceptionalism has been called into question, but investors aren’t in a mood to let go of the Magnificent Seven, even at pricey valuations. The latest Bank of America fund managers' survey shows that investors are long stocks and short everything else.

There is always a gap between ground zero facts and fundamentals on the one hand, and stock prices on the other, because the latter capture the potential of facts and fundamentals changing in future. But when this gap widens far more than warranted, things get challenging, and a dash of honesty is needed. While it is to be seen whether the US bond market would discipline the Trump administration, there is a dire need to show some integrity to valuations across the globe. For India, honesty has already begun at home.

Investing insights from our research team

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Technical Picks: NATIONALUM, ICICIBANK.

Aparna Iyer
Moneycontrol Pro