It usually bounces over the head when we hear economic terms, cycles, interest rates, supply and demand. But I really found Ray Dalio`s articulation of economic cycles very insightful. Ray Dalio, founder of the Bridgewater Associates, the largest hedgefund in the world, definitely is the most authoritative voice when it comes to investing and understanding economic cycles .

I have also tried to put in simple terms what I understood from my reading and analysis on what the current economic situation is and the impacts of interest rates. Below is the article,

FED QE unwinding & Impact of rising US yields on Emerging Economies

This has no significance in the process of long term investing in great businesses and creating wealth from long term like 8-10 years standpoint. This is good to know information on how interest rates will influence the direction of markets in short to medium term.

What was Quantitative easing in 2008, Fed policies and QE unwinding:

During Financial crisis, Fed bought Treasury securities (Bonds)/ Mortgage backed securities or MBS (holds $1.74 Trn MBS backed by Fennie Mae, Freddie Mac). This was called the Quantitative Easing (QE). With the economy bouncing to (4% GDP growth) and Inflation & wage growth inching up, Quantitative Easing unwinding by FED has been initiated since a year or so. During QE Unwind process which started in Oct 2017, FED will accelerate shedding off of those securities by around $50 Bn/ Month starting Q4 2018. The balance of Treasury securities is $2.32 Trn after shedding $152 Bn so far in treasuries. The FED lets bonds roll off when they mature and do not abruptly sells off outright. Based on the current plans of Fed`s normalization, they will shed all MBS and retain only Treasury securities. Fed`s total Assets as of date is around $4.3 Trn. Fed had pumped in money during QE, increasing liquidity in the system and when it unwinds, the money gets destroyed there by taking back Fed`s balance sheet shrinking to a value bit higher than prior to QE dates. There is definitely increase in net addition of GDP and other Governments deposits and other actions with new balance sheet assets after QE unwinding might be in the range of $2.4-2.9 Trn.

Economic growth, rising yields and Interest rates:

Rise in wage growth as well as inflation will demand interest rates hike by Fed which will tighten the easy credit availability in the US economy. During September 2018, US treasury 2–Yr has risen to 2.74 while 10 –Yr has risen to 2.97 percentage.

At this stage when the yields are floating just around 3% on US 10-Yr treasury bonds and any further rise from here will make the 10 Yr loans and 30 year mortgages dearer commensurately. The yields on treasuries are just the inverse of the demand for the US treasury bonds. When the demand for bonds drops, bond values drops and hence the yield will rise. FED reserve uses the 10 yr treasury yield as a barometer to regulate monetary policies.

At this point, this rate cycle exudes the confidence on economy and real strength substantiated by growth and job reports. The investors expect less yields on short term treasuries whereas expect higher yields for long term lock-ins. But if you notice the spread between 10-Yr and 2-yr is only 0.23 basis points and if this gap recedes further, then it will result in an inverted yield curve which would indicate that the markets has lost confidence on the prospects of economy and at the same time headed to recession. Inverted yields occurs when short term treasury rates go higher past the 10 –Yr treasury yields since investors would settle in for low risk low returns on the long term safety treasurys amidst the panic economic conditions. This might be the next stage and nobody can predict the exact timing of these extreme events though economic experts can predict the directions and cycles at high level.

Impact on Emerging Economies:

Rising US interest rates and tighter monetary policies has profound implications in emerging economies as well, such as foreign investments in emerging economies shifting back to dollar safety at higher returns and hence the commensurate currency depreciations. This will have higher impact on countries with Current Account Deficits (CAD) whose economies are more dependent on higher imports bills, with large dollar denominated international debts and the likes. Case in point: India has huge dependency on energy and gold imports and oil prices going up is a double whammy. The saving graces at this moment for India are low historic inflation levels at 3.9 and high forex reserves at around $400 Bn to fund the deficits as the need arises. But the currency will normalize at some point where the emerging markets will look attractive from equity and debt investment standpoint. Global pension funds are starving for high growth investment arenas and the foreign inflow will surge back to the emerging economies due to value emerging which will stabilize currencies in future.