Emerging markets can weather the hawkish Fed storm
Nicholas Spiro says the prospect of the US Federal Reserve raising interest rates three more times this year has unsettled investors, but emerging markets have remained resilient so far
Signs that international investors are starting to position themselves for a more hawkish Federal Reserve are becoming more apparent by the day.
Last Friday, data from the Commodity Futures Trading Commission showed that speculative investors upped their bearish bets in 10-year Treasury futures to the highest level on record, following the rise in the yield on the benchmark US bond to just over the symbolically important level of 3 per cent.
The probability that the Fed will raise interest rates three more times this year, rather than the two additional hikes forecast by the central bank, is now approaching 40 per cent, roughly double the odds at the beginning of April.
The sudden repricing of US interest rate expectations is fuelling a rally in the dollar which is putting emerging market assets under strain. Last week, Argentina and Turkey were forced to raise borrowing costs aggressively to shore up their currencies. The MSCI Emerging Markets Currency Index, a gauge of developing economies’ currencies, is down 2 per cent since early April while inflows into emerging market bond and equity are drying up, and in certain asset categories have turned into outflows.
The Institute of International Finance (IIF) says the abrupt rise in US bond yields and the dollar echoes the 2013 “taper tantrum” when emerging market assets were pummelled by the Fed’s decision to wind down its quantitative easing programme.
While it would be a mistake to underestimate the risks posed by a more hawkish-than-anticipated Fed, it would be equally wrong to play down the resilience of emerging markets.
The sharp fall in the yield on China’s 10-year government bond, which has fallen 35 basis points since the end of January to 3.65 per cent (and was as low as 3.5 per cent on April 20), is the most obvious example of the strong performance of emerging market assets in the face of tightening global financial conditions.
China’s bond rally has eroded the yield premium over 10-year Treasuries to just 65 basis points – down from more than 160 last November – and turned the country’s local currency debt into this year’s best performer in the Bloomberg Barclays Global Aggregate Index, a leading gauge of sovereign and corporate bonds.
Other examples of the resilience of emerging markets include central and east European bonds. These are much more influenced by the policies of the European Central Bank, which, in response to a slowdown in the euro zone, may be forced to delay the end of its quantitative easing scheme.
The yield on Poland’s domestic 10-year debt has plunged 60 basis points since early February. Meanwhile, spreads, or the risk premium, on junk-rated emerging market corporate bonds have fallen by 6 basis points over the past month and remain close to their lowest levels since the global financial crisis, according to data from JPMorgan.
Still, there is a limit to the outperformance of emerging market assets in the current environment.
While the decline in China’s bond yields stems partly from recent signs that the economy is weakening, a gap of just 65 basis points between China’s 10-year yield and its US equivalent diminishes the appeal of yuan-denominated assets and casts doubt on Beijing’s commitment to crack down on financial risk, which, presumably, would call for tougher measures to head off another bond bubble.
A bond rally fuelled by expectations of a further easing of monetary policy following the People’s Bank of China’s recent decision to cut the required reserve ratio would cause the divergence between US and Chinese debt markets to widen too far. Deutsche Bank has rightly warned that Chinese government bonds have become overpriced.
Much now hinges on the direction of US Treasuries – particularly the closely watched 10-year yield – and the dollar.
If America’s inflation rate keeps inching up, US bond yields will continue to rise, bolstering the dollar and putting emerging markets under more pressure.
A 10-year Treasury yield of just over 3 per cent is already proving to be a more attractive buying opportunity for bond investors, particularly Japanese investors who face a 10-year yield at home that is barely above zero per cent. Bank of America Merrill Lynch noted last week that foreign buying of Treasuries has surged to its strongest level since February last year.
If this trend persists, the 10-year yield could start falling again, easing the strain on emerging market assets.
For now, the IIF’s fears of another taper tantrum look overdone.
Nicholas Spiro is a partner at Lauressa Advisory