Rising rates not always emerging markets poison

July 31, 2014

July 31 (Reuters) – The taper tantrum was brutal, but rising
rates do not have to mean lousy performance for emerging

As investors look to the possibility of rising official
interest rates in the U.S. and Britain in the coming year their
expectations are colored by nasty memories of 2013’s taper
tantrum, when bumbled communications by the Federal Reserve
caused Treasury yields to spike and emerging markets to suffer.

Asset performance was both volatile and very poor,
particularly among emerging market countries like India and
South Africa which need to attract capital flows from abroad.

But much depends on why rates are rising, rather than just
the direction.

“Higher interest rates and exit from monetary stimulus in
major advanced economies when led by stronger growth prospects
produce good spillovers,” according to International Monetary
Fund economist Hamid Faruqee, one of the authors of a report
this week on the potential impact of interest rate
normalization. (here)

“Interest rates tend to rise elsewhere. But they are lifted
by a rising tide of economic activity at home and abroad.
Another positive development is that trade and capital flows
tend to strengthen.”

That’s in contrast to last year, which was more of a money
shock, in which interest rates rose more rapidly than can be
justified by the performance of the real economy. Those sorts of
tightenings, of which the taper tantrum is just the latest
example, are characterized by tougher conditions in capital
markets, outflows of capital from weaker emerging markets and
lower overall cross-border flows.

In other words, if rates rise because a strong recovery
dictates they should, emerging markets will do just fine. If,
however, rates go up to control inflation without a recovery or
to tamp down speculation, then watch out.

Janet Yellen’s clearly enunciated policy of not using
monetary policy to control risk taking, relying instead on
macroprudential tools like regulation, is great news therefore
for emerging markets. Or at least will be so long as that
remains policy.

Of course any transition from an unprecedented situation
bears risks, and surely emerging markets will be highly
dependent on how well the Fed manages the transition away from
zero interest rates and the eventual runoff of its massive
balance sheet.


And while last year’s tantrum is seared into investors’
memories, the recent history of Treasury yield spikes and their
impact on emerging market currencies and interest rates is
relatively benign.

Analysts at Societe Generale looked at the 16 instances
since 2000 in which long-term Treasury yields spiked by more
than 50 basis points in three months or less and found that a
basket of emerging market currencies weakened by only 0.4
percent on average.

Spikes had a bigger impact on the oil price, which rose by
nearly 9 percent on average, which in turn might hit emerging

“A marked increase in oil prices has historically been
associated with a negative impact on emerging markets. It
therefore makes sense to keep an eye on the oil price action,”
Socgen analysts Benoit Anne and David Hok wrote in a note to

In some ways the Treasury spike which might tell us most
about the next year was the one which happened in 2004, when the
market correctly anticipated a tightening cycle after a change
in Fed language in its March policy statement. That drove a 15.5
percent spike in oil and hit some emerging markets hard,
particularly Brazil and Turkey.

Overall, though, many emerging markets recovered their
previous levels in several weeks and good global growth
prospects helped to underwrite a strong rest of the year.

For 2004 to trump 2013 the conviction that the Fed and BOE
will hike needs to be accompanied by stronger evidence that they
are doing so for positive reasons. Wednesday’s Fed statement was
more reassuring than encouraging, highlighting several reasons,
notably weakness in housing and labor markets, which might
justify a delay in rate hikes for some time.

That focus on labor markets, particularly on wage growth,
makes Thursday’s news that the employment cost index rose at a
brisk 0.7 percent clip in the second quarter very significant
for emerging markets.

That gain, the fastest rise in U.S. employment costs since
2008, could be an early sign that wages are finally improving.

Several more months of that and we could be looking at a
rate-hike cycle which is good news for the global economy and
emerging markets.

If that doesn’t arrive, emerging market investors had better
hope that financial market bubbles don’t force the Fed into
hiking despite sluggish growth.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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