Emerging markets still haunted by the Fed
With the genie of tapering out of the bottle, the Fed will haunt emerging markets for some time, despite the rally across asset classes
A year ago, when the United States Federal Reserve signalled its intention to start withdrawing its huge monetary stimulus, emerging markets sold off sharply and indiscriminately.
Now, as the Fed continues to scale back, or taper, its asset purchases, the shift towards tighter US monetary policy appears to be having little effect on emerging market assets.
Investor sentiment towards developing economies has been remarkably bullish over the past four months. Even the last bout of nervousness in January had more to do with issues specific to these markets rather than fears about the Fed.
The facts speak for themselves: the average spread on emerging market dollar-denominated bonds - which stands at 285 basis points, or 2.85 percentage points - is now more or less at the same level as in early May last year, just before the Fed let the "tapering" genie out of the bottle.
The average yield on local currency debt - which is riskier given the vulnerability of many emerging market currencies - has fallen to 6.5 per cent from nearly 7.2 per cent in January.
Equities have risen 5.1 per cent over the past three months, with the stock markets of Russia and Turkey rising 9 per cent and 11.4 per cent, respectively.
Sentiment-wise, one could be forgiven for forgetting that several vulnerable emerging markets had ever been dubbed the "Fragile Five". The currencies of three members of this group - Turkey, India and Indonesia - have risen 8 per cent, 4.7 per cent and 3 per cent, respectively, against the US dollar since the end of January.
Indeed, so dramatic is the four-month-long improvement in sentiment - fuelled by the "reach for yield" among investors - that there is even strong demand for the bonds of more exotic frontier markets.
On Monday, Kenya raised US$2 billion - four times the amount it envisaged - in the largest debut for an African economy in the sovereign debt markets. The yields on the country's five- and 10-year US dollar-denominated bonds, at 5.8 per cent and 6.8 per cent, respectively, were lower than expected.
On close inspection, however, the emerging markets rally lacks conviction and could easily go into reverse. For starters, the Fed has not yet agreed on a roadmap for "policy normalisation" and has been pacifying markets - to the point of reducing volatility to worryingly low levels - by putting off a decision on its exit strategy, particularly how it will go about raising rates in the first half of next year.
While the initial shock of the "taper" has worn off, the Fed will nevertheless struggle to signal a tightening in policy without unsettling markets.
From an emerging markets perspective, the external vulnerabilities of the asset class associated with a rise in US Treasury yields not only persist but have the potential to undermine sentiment significantly.
The last six months - in which the yield on 10-year US debt has fallen from 3 per cent to 2.6 per cent - have provided a respite for developing economies, notwithstanding the sell-off in January.
Second, and most worry-ingly, the rally is driven by technical factors (capital flows and investor positioning) as opposed to fundamental ones (a belief that the structural underpinnings of the asset class are improving).
Several large economies, notably Russia and Brazil, have slowed to a crawl, while many others, such as Turkey and South Africa, have yet to correct their sizeable macroeconomic imbalances.
Even in India, where markets are the most sanguine about the prospects for much-needed fiscal and structural reform, there is an inescapable feeling that investors have got ahead of themselves.
The sharp rise in oil prices stemming from the recent turmoil in Iraq is threatening those markets, such as India and Indonesia, that are heavily reliant on oil imports and suffering from high inflation rates.
Third, investors themselves have become increasingly complacent as market volatility practically disappears.
A good example of this is the dramatic shift in expectations for interest rates in emerging markets. As recently as March, markets were pricing in 100 basis points of rate increases in Hungary over the next 12 months, partly because of fears that the country's central bank had become too dovish.
Now, investors expect rates to remain unchanged, even though the central bank continues to trim rates.
Still, sentiment towards emerging markets remains fragile. Over the past three weeks or so, currencies have come under pressure.
The South African rand and the Turkish lira have lost 5 per cent and 3.3 per cent, respectively, against the US dollar. Even the Indian rupee has fallen 2.6 per cent.
While this is partly due to the escalating conflict in Iraq, the sharper-than-expected rise in the US inflation rate last month is contributing to the growing perception that interest rates may rise sooner than expected.
Expect the Fed to continue to haunt emerging markets for some time yet.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy