• The withdrawal of liquidity by the US Fed could be exacerbated by the effect of last December’s tax cuts.
• It could give rise to a disorderly transition for emerging market economies, many of which raise debt in US dollars.
• The resulting fallout also poses significant risks to the global economy.
• One senior bond trader told Business Insider they are “frustrated that it is taking as long as it has to be discussed”.

The US Fed is staying on track to tighten monetary policy amid as the economy strengthens — but that could spell serious trouble for emerging markets (EM).

And according to multiple analysts, markets may still be underestimating the risks not just to EMs, but the global economy as a whole.

No one knows exactly how the withdraw of monetary stimulus will play out — mainly because the emergency settings enacted by global central banks in response to the 2008 financial crisis were themselves unprecedented.

But a recent run of strong data has reaiffimed the Fed’s guidance, and it remains further along its tightening path than other central banks.

And the effect of last December’s tax cuts mean the withdrawal of USD liquidity could become even more drastic.

As the world’s most liquid currency, USD-based transactions are central to global market functions.

Data from the Bank of International Settlements showed “total dollar-denominated debt outside the U.S. reached $US10.7 trillion in the first quarter of 2017”. And about one third of that is owed by the non-financial sector of emerging economies.

Already, some cracks have begun to appear in emerging asset classes, which were some of the best performers on global markets in 2017.

Emerging markets currencies — led by falls in the Argentinian peso and Turkish lira — have recently come under pressure, and BAML analysts said other EM currencies are looking vulnerable.

And the problem is clearly on the radar of industry professionals.

One senior bond trader told Business Insider they’ve held the same view on liquidity withdrawal for years were “frustrated that it is taking as long as it has to be discussed”.

Those concerns were highlighted last week by Urjit Patel, the governor of the Reserve Bank of India.

Patel wrote in the FT that if the US maintains its current pace of monetary withdrawal it could have serious repercussions for the global economy.

While the US Fed is on track to raise rates at least twice more this year, Patel’s focus was on the continued reduction of its bond-purchasing program in the wake of the Trump administration’s tax cuts.

The US Fed is now maintaining its stimulus-withdrawal program, at the same time as bond issuance is increasing to fund increases in the fiscal deficit stemming from the tax cuts.

And if the Fed doesn’t change course, Patel said the subsequent decline in USD liquidity means a “crisis” in global bond markets denominated in US dollars will become “inevitable”.

IG Markets Senior Strategist Ilya Spivak told Business Insider that he shares a similar view about the pending risks from reduced USD liquidity.

“I tend to agree that the markets are not appreciating the knock-on effects of Fed policy,” Spivak said.

“For the first time in a decade, global quantitative easing will turn to tightening in the second half of this year as Fed balance sheet reduction outpaces ECB bond purchases.”

The resulting decline in liquidity will leave “emerging market assets on the front lines of the selloff”, Spivak said.

While no one knows exactly how it will play out, more leading investors are highlighting the risks on the medium-term horizon posed by the withdrawal of liquidity.

Earlier this week, Bridgewater Capital — the world’s biggest hedge fund run by billionaire Ray Dalio — warned that danger lurks for markets in 2019. This has been echoed by JP Morgan’s team of global rates strategists.

Based on the change in circumstances in the wake of the Trump administration’s tax cuts, Patel said the US Fed’s approach to liquidity withdrawal should also change.

While the US Fed doesn’t set monetary policy with respect to India, the recent comments by analysts, investors and policy makers suggests it’s an area that warrants proper attention in the months to come.

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