EMD Relative weekly notes
Week Ending August 26, 2016
One of the risks for emerging markets is any ripple in the so far quiescent river of free flowing monetary stimulus that has allowed currencies to rally this year from historically oversold levels. One of those is perhaps developing now as the Federal Reserve seems determined to have the market raise the probability of an interest rate hike this year. Given the sheer amount of stimulus and the urgency in the global yield hunt, we doubt that this event will seriously dent dollar bond prices over an extended period. But it could introduce some volatility into local currency investing over a multiple month period. Should this play out, an over-reliance on local currency appreciation to generate gains in EM is in the near-term more at risk than a more balanced approach across the entire opportunity set.
The chart below shows the two-year treasury bond yield since the Brexit vote in late June. With December rate hike probabilities currently at 57%, the Fed has more work to do if they truly want markets to avoid being caught off-sides by a 2016 hike. The dollar index over the past week has risen, though only modestly.
Source: Bloomberg; data as of August 25, 2016. Past performance is no guarantee of future returns.
The combination of these indicators is historically correlated to softer performance from EM FX, yet the local currency index is up about 2% month-to-date for a third consecutive positive monthly performance—thus it appears little attention has so far been paid.
The Atlanta Fed's Nowcast GDP forecasting model is currently predicting third quarter growth will come in at 3.4%. If that holds up in the face of new data, we would conclude that the Fed will be forced to ratchet up the rhetoric to keep rate hike probabilities moving higher, which would increase the odds of the dollar rising further.
Of course, the market's reaction function to the Fed, if vigorous enough, could itself unwind those probabilities as we have seen before. So radical shifts in EM risk exposures are hardly warranted given the evidence today. Yet when historically reliable indicators begin to move, attention should be paid. We believe an approach to EM of generating dollar income without an excessive reliance on FX appreciation will likely continue to produce results that compare favorably to other asset classes, which are also vulnerable to Fed dynamics--especially other fixed income categories shorn of the cushion that yield may lead to short-term negative price movements.