The Fed calls time on the rally in emerging markets

It was fun while it lasted.

Even before last week’s publication of the minutes of the US Federal Reserve’s April policy meeting which revealed that most policymakers felt it would be “appropriate” to raise interest rates next month, provided economic data remain favourable, investor sentiment towards emerging markets (EMs) was beginning to deteriorate.

The MSCI Emerging Market Index, a leading gauge of the performance of equity markets in developing economies, surged 20 per cent between February 12 and April 21, It has since fallen more than 6 per cent, with most of the decline occurring before the relatively hawkish minutes of the Fed’s April meeting that were published on May 18.

Yet with the sudden prospect of a further increase in US rates at the Fed’s next meeting on June 14-15, bond investors now see a more than 30 per cent chance of a hike next month and a roughly 50 per cent probability of one in July. They priced in just a 4 per cent chance of a June hike before the April minutes were published. And that has pulled the rug out from under a rally that never looked convincing from the start.

Many EM currencies suffered sharp declines last week, with the South African rand, the Russian rouble and the Indonesian rupiah all falling more than 2 per cent against the dollar, although in some cases because of idiosyncratic factors. EM equity funds, which enjoyed sizeable inflows in March and April, are once again suffering outflows.

While there is none of the panic which characterised previous sell-offs — in particular the so-called “taper tantrum” in 2013 which stemmed from the unexpected decision by the Fed to begin scaling back its asset purchases — bond investors are nervously repricing US monetary policy, contributing to a rally in the dollar, with the dollar index (a gauge of the performance of the greenback against a basket of its peers) surging nearly 3 per cent since the beginning of May to now stand at an eight-week high.