Funds exiting the US too!

Everybody understands that emerging market currencies, including the Indian rupee, have tumbled largely in response to the expectation that the Fed will taper off quantitative easing (QE)in the months to come. With QE, the Fed buys long-term US securities; this increases money supply in the US, not all of which can be absorbed within the US. Much of it has been spilling into emerging markets. When QE is tapered off (that is, withdrawn gradually), US money supply will fall, bond yields will rise, thus pulling funds out of emerging markets back into the US.

So far, so good. But if US funds are heading back into the US, foreign funds, notably from China and Japan, are leaving the US, as an article in the FT points out. Foreigners have turned net sellers of US securities. Chinese and Japanese funds are exiting the US:

Net sales of long term securities in June came to $66.9bn. This is the biggest sell-off since August 2007 when foreigners sold $72.9bn of such securities as the credit crunch provided the curtain raiser for the financial crisis.

The focus of the sell off in June was primarily in the bond market where cumulative net sales of Treasuries and government agency bonds amounted to $95.2bn in the three months to the end of June. But equities were hit too. Net sales by foreigners of $25.5bn amounted to the second biggest disposal of the past 35 years, after the record sale of $39bn in August 2007.

Why are China and Japan exiting the US? Because they want to boost domestic consumption. This means a fall in saving and hence a fall in surpluses that can be exported to the US. If the Fed is tapering off QE and big investors in US securities, such as China and Japan, are exiting, then we should see a significant rise in bond yields in the US. That bodes ill for investment in emerging markets, especially emerging market bonds.