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Why the Fed’s actions are hurting markets

Paddy Hirsch Aug 20, 2013

We’re reading a number of stories about the effect that an expected slowdown in the Federal Reserve’s bond-buying program is having on emerging markets. They’re all missing a central explainer of why these markets are hurting.

Here’s my take:

The Fed’s program pumped lots of cheap cash into the system – call it a bond-buying, stimulus or liquidity program. A lot of people used that cheap cash to invest in emerging markets.

And as investors anticipate the Fed putting the brakes on the program, two things are happening simultaneously.

  1. Investors figure there’ll be less cheap money coming out of the Fed, which means there’ll less money going in to so-called emerging markets. That will cause a slowdown in economies like Indonesia and India. And no-one wants to have their money in an economy that’s slowing down. So investors are pulling their money out.
  2. Investors are nervous the entire financial system will slow down with less cheap money, so they’re piling back into safe stuff –- which means they’re moving even more cash out of emerging markets and into safer, U.S. investments.

Together these actions translate to one big flight of cash away from emerging markets. And while no-one is in big trouble yet, we’re already seeing the effects of this so-called flight of capital.

An analogy: Imagine you’re living a high-flying, American Express Gold Card executive lifestyle. You use your big paycheck to buy a big car and a big mortgage and send your kids to Ivy League schools, and you amass big credit card bills, that you are having no problem paying off.

And then one day your boss comes into your office and tells you revenues are down at the firm and everyone’s income is going to be cut in half — including yours. Suddenly you’re going to have problems paying your mortgage, your credit card bills and your kids’ tuition. You may even have trouble fueling your car and feeding your family.

That’s how those emerging nations feel.

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