Emerging markets bounce back but will a hawkish Fed inflict more pain before long?

Emerging-market policymakers have breathed a sigh of relief in the past few weeks. Having just suffered their longest sell-off since the global financial crisis – data from Bloomberg shows the price declines in the stocks, currencies and foreign currency bonds of developing economies have lasted longer than the seven previous major sell-offs since 2008, measured by the number of days from peak to trough – emerging markets have rebounded this month.

Since September 11, the MSCI Emerging Markets Index, a leading equity gauge for developing nations, has risen more than 4 per cent, having fallen into a bear market at the start of this month. Another benchmark gauge that tracks the performance of 25 emerging market currencies is up more than 1 per cent, following a 7.5 per cent drop since late March. Foreign investors, meanwhile, have started to move back into the asset class: the largest exchange-traded fund tracking hard-currency emerging market bonds just enjoyed its biggest daily inflow since June 2017, according to Bloomberg.

While sentiment towards developing economies remains fragile and could easily deteriorate again due to country-specific and external factors, the tentative recovery stems from the end of a four-month rally in the US dollar, which had put emerging markets (particularly those with large external financing requirements) under severe strain.

Since mid-August, the US Dollar Index – a gauge of its performance against a basket of other major currencies – has fallen 2.7 per cent, to its lowest level since early July.

While this can partly be explained by renewed demand among investors for so-called risk assets, the dollar has also depreciated against major developed market currencies, losing 3.7 per cent against the euro since August 14. This is striking, given the strong support the US dollar ought to be receiving from the huge-yield premium Treasury bonds are trading at versus their German equivalents, with the yield differential between benchmark 10-year Treasuries and German Bunds currently exceeding 250 basis points, the widest spread since the 1980s.

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Currency investors, moreover, still remain extremely bullish on the dollar. According to the latest fund manager survey published by Bank of America Merrill Lynch last week, a long, or overweight, position on the US dollar is one of the most popular trades in markets, together with bullish wagers on leading technology stocks and bets against emerging market equities.

All this suggests that dollar bulls have got ahead of themselves.

The breakdown in the link between US bond yields – the 10-year yield has shot up almost 25 basis points since late August and is once again trading above the psychologically important 3 per cent level – and the dollar could be a sign that America’s rapidly deteriorating fiscal position, coupled with its widening current account deficit, is beginning to chip away at the status of the US dollar as the world’s main reserve currency.

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A more plausible explanation for the dollar's sudden fall is that investors are questioning the extent to which the Federal Reserve can keep increasing interest rates without endangering America’s economy and are shifting their gaze to the next big cycle of monetary tightening: the first increase in rates in the euro zone following the end of quantitative easing in December. On Monday, German bond prices fell after Mario Draghi, the head of the European Central Bank, forecast a further rise in inflation within the bloc as wage growth picks up.

Still, the dollar could bounce back sooner than many think.

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On Wednesday, the Fed brushed aside concerns about the impact of the trade war on America’s economy by raising rates for the third time this year and signalling that it intends to push ahead with its plans for another four hikes by the end of 2019. The fact that the US central bank, under its new chair Jerome Powell, is determined to tighten policy further in the face of an intensifying trade war and an inflation rate which, while having risen markedly, remains relatively subdued suggests investors are underestimating the Fed’s resolve to raise rates.

If bond markets start to price in a faster pace of tightening next year – the odds of additional rate increases in 2019 were already rising before Wednesday’s Fed meeting – the link between Treasury yields and the dollar could reassert itself, driving up the US dollar.

The recent improvement in sentiment towards emerging markets could be short-lived.

Nicholas Spiro is a partner at Lauressa Advisory