Hard times for EM in QE-less world of higher US yields

April 4, 2012

Now that the Fed appears to have dashed any lingering hopes for an imminent QE3, what’s next for emerging markets? Most observers put this year’s stellar performance of emerging bonds, currencies and equities largely down to the various money-printing or cheap money operations in the developed world. That’s kept core government bond yields bumping along near record lows and benefited higher-yielding emerging assets.

Many would add that in any case a solid economic recovery in the United States should be fairly good news for the rest of the world too. Not so, says HSBC. It argues that a better U.S. outlook is not necessarily good news for emerging markets simply because the side effect of economic improvement is a stronger dollar and higher Treasury yields and that’s an environement in which EM assets tend to underperform.

For an example, it looks back to the days between November 2010 and Feb 2011 when signs of improvement in the U.S. economy steepened the U.S. yield curve,  pushing the spread between 2-year/10-year Treasuries almost 100 bps wider.  Flows to emerging markets dipped sharply, the following graph shows:

Money did continue to flow into emerging local bonds and equities in this period, albeit at a slower pace. But from local bonds the return was negative, HSBC notes. That could be an indication of what’s to come:

The carry trade is not dead yet but the change in tone by the Fed suggests it may have passed its best days.

Headwinds for emerging markets may in fact be greater now than 18 months ago.  U.S. growth expectations haven’t budged much HSBC says:  the bank expects U.S. growth under 2 percent this year and in 2013. On the other hand emerging market output gaps are much tighter than they were 18 months back and oil prices are higher. That makes the outlook for emerging local currency bonds more challenging,  especially as a  stronger dollar will give EM currencies less room to rise.

Should ongoing improvements in U.S. data result in further hawkish moves from the Fed and if such changes see U.S. yields rise further, we would expect this to be positive for the dollar vs EM . The combination of a potentially more inflationary backbone and a more challenging backdrop for EM FX might become a headwind for local rates.

Still, the Fed has signalled that its key interest rate will stay at current near-zero levels until 2014.  Investors will be hoping that at least that pledge remains in place.

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