Fixed Income

EMD Relative weekly notes

Week Ending May 20, 2016


James Barrineau

James Barrineau

Co-Head of Emerging Markets Debt Relative

The Fed's determination to force markets to price in a higher probability of a June or July interest rate hike, expressed this week in speeches and the release of meeting minutes, is an unambiguously short-term negative for emerging market (“EM”) local currency investing. It has worked to boost short-term interest rates in the US and strengthen the US dollar. Investors, whether prescient or lucky, were already trimming their exposure to local currencies as inflows into these funds were negative for the two prior weeks while dollar inflows remained positive (although smaller).

So the question of the day is whether this portends a move similar to the long fall in EM currencies from June of 2014 to January of this year, and whether the entire asset class will come under sustained pressure. We think there are extremely compelling reasons to believe this will not be the case. Further, dollar EM assets continue to look more and more attractive relative to the global fixed income asset class, in our view, and we do not expect spreads to widen on a sustained basis.

Here are the reasons why we believe the current episode will be far briefer:

− Financial conditions have already accomplished some tightening for the Federal Reserve. In the previous episode, markets—and the US dollar—had a long climb to acknowledge the beginning of a hiking cycle after years of inactivity. The chart below of the US two year Treasury bond shows that since the beginning of May yields have risen to price in another interest rate hike. In lockstep with this move, the dollar index rose 3% over the same period. Both developments represent financial tightening that works to accomplish the same thing as rate hikes by the Federal Reserve 

Source: Bloomberg, US 2 Year Treasury Note; data as of May 20, 2016. Past performance is no guarantee of future results.

− The Chinese currency, CNY, has already quietly depreciated 1.4% versus the dollar since the end of March. A significant further fall in the currency would represent a risk to all asset classes, yet this episode has so far passed unnoticed. This development seems to validate our thesis that Chinese officials have learned from the two previous episodes of sudden currency shifts that caused sharp market falls. 

− Unlike the 2014‒early 2016 period, the European Central Bank does not seem interested in using looser monetary policy to weaken the Euro. That means the divergence in developed market monetary policy seen earlier is highly unlikely to repeat even if the Fed hikes interest rates in the coming two months. It was that divergence—not just the Fed's market preparations—which helped cause the stratospheric USD rise that began in June of 2014 and led to historically unprecedented EM local currency losses.

If we are right, then those investors who tactically reduced local currency exposures while maintaining their EM dollar assets (currently offering very attractive yields relative to the rest of the globe) may end up being well-positioned for attractive 2016 gains in this asset class.


  • Fixed Income
  • US