Battle-hardened emerging-market investors have seen this movie before: A U.S. Federal Reserve interest-rate hike triggers a jump in nominal local rates in emerging markets, especially those with fixed or semi-fixed exchange rate regimes. Hot money flows out of developing nations, across FX, equity and fixed-income markets. Local currencies weaken against the dollar. And the ensuing jump in the cost of dollar liquidity, and declining portfolio flows, spark fears over the debt-servicing capacity of emerging-market borrowers.
In short, the boom-and-bust capital-flow cycles in emerging markets over the past three-decades have roughly followed this script.
Fast-forward to September 2016: markets are raising their bets that the Fed will hike rates this year — raising fears the post-Brexit-vote inflow party in emerging markets might ease, while international financial conditions, more generally, might tighten. Now, analysts say that the outlook for EM asset classes hinges on how the U.S. yield curve reprices in the coming months.
In short, the shape of the Treasury yield curve and the level of long-term U.S. real rates, in particular — rather than the absolute level of U.S. short-end rates — will be crucial in driving capital flows into emerging markets, analysts say.
Sebastian Raedler, equity strategist at Deutsche Bank AG, is one analyst who urges caution, citing EMs' dependence on U.S. monetary policy. EM portfolio flows tend to follow developments in the U.S. yield curve with a two-year lag, he says, suggesting financial conditions could tighten significantly in emerging markets if the Fed becomes notably more hawkish.
"It's very clearly the case that low U.S. rates are historically a push factor for foreign capital flows into emerging markets," Raedler says. "The best scenario to support continued inflows into emerging markets is that financial conditions remain benign. But, thinking about the 30-year history, investors tend to love EM the most when the party in U.S. monetary policy — low rates — is in full swing."
Analysts say emerging markets could absorb a single Fed hike provided expectations for 2017 are for a shallow tightening cycle, which would anchor long-term U.S. rates. They cite still-high yield and growth differentials in favor of emerging markets, as well as their stronger current account positions compared with the sell-off that roiled developing nations during the 2013 Fed taper tantrum.
These factors have helped to buoy portfolio flows into developing nation's debt markets, which have reached all-time records in recent months. In July, the Institute for International Finance (IIF) estimated that non-resident portfolio flows to emerging markets reached $24.8 billion, following $13.3 billion in June. But the EM inflow party is complicated by divergent signals sent by Fed officials last week.
Fed Vice Chair Stanley Fischer's explicit signal last Friday that two rates hikes by year-end were a realistic possibility sent a hawkish message to markets, driving an increase in short-end U.S. government yields, though the market-implied probability of a hike in September has eased in recent sessions.
At the same time, markets have taken comfort from Fed Chair Janet Yellen's suggestion that same day that the average level of the nominal federal funds rate down the road, when the economic cycle normalizes, could be just 2 percent, a prospect that would anchor the long-end of the U.S. rates curve in the years to come.
This, therefore, puts emerging market investors in a bind: expectations of a near-term rate hike are rising, while Fed officials are signaling dovish expectations with respect to future rate increases and the term premium.
A bear-flattening of the U.S. yield curve — whereby front-end rates move higher but the long-end remains relatively well-anchored — mimics the 2004-2007 U.S. hiking cycle, which coincided with strong performance of EM assets, while the current account positions and real yields in developing countries are "also back at levels corresponding to the mid-2000s," according to analysts at Goldman Sachs Group.
In a note published Wednesday, the team led by Kamakshya Trivedi, wrote, "So, while we remain cautious on China-linked currencies, the improvements in EM external balances and real carry means that they should be able to better absorb a gradual US hiking cycle where long-term rates remain well anchored."
The outlook for real U.S. yields matters too.
Stoyan Dogandzhiyski, emerging markets strategist at BNP Paribas SA, said, "During the 'Taper Tantrum' in May 2013 and the EM sell-off at the end of 2015, and the beginning of 2016, the U.S. real yield curve steepened, with the long-end moving towards positive territory, which triggered a 'sudden stop' in capital flows into EM." However, with the five-year five-year real rate in the U.S. trading in negative territory, the investment case for EM assets, based on the higher yields on offer, remains sound, he says.
The Goldman analysts add that an unanticipated 10 basis point Fed hike is sufficient to trigger a synchronized sell-off with higher local EM yields, wider EM sovereign credit spreads as well as weaker currencies and stocks. This echoes a Bank for International Settlements report last month, which showed a rise in U.S. short-term yields on the back of a well-flagged Fed tightening cycle,don't materially hike long-term yields in emerging markets. But shifts in long-term U.S. Treasury yields do.
Drawing on historic data, the Goldman analysts say the results of Fed policy shocks differ between asset classes. "These historical estimates suggest that if Fed communication continues to push towards disparate moves in rate expectations (higher) and the term premium (lower), the recent rally in EM equities would be most at risk, whereas EM credit and rates would be better insulated, with EM FX lying somewhere in the middle."
Even in the event of a rate hike, analysts say EM fixed-income markets could stay stable amid a benign climate for global credit, though it might be a different story for FX markets.
Fixed-income analysts at Credit Suisse AG, led by Kasper Bartholdy, for example, wrote in a report on Wednesday that, "While valuation arguments based on long-term economic relationships tend to favor EM currencies over EM credit at present, further increases in U.S. short-end rates would cause further weakening of EM currencies against the dollar, even as the stability of the longer end of the U.S. rates curve would help support the performance of EM credit, in our view."
In short, the shape of the U.S. yield curve will hold the key in driving EM sentiment — as much as the discrete event of Fed rate hikes.