Market Views: Fixed Income
Schroders Quickview: What does a more hawkish Fed mean for EM debt?
A moderately more hawkish Federal Reserve—which on Wednesday opened the door wider for a December rate hike—will perhaps stall a recovery in emerging market currencies, but the global search for yield will likely keep dollar denominated emerging market debt from retreating in price substantially.
EMs price in Fed rate hike
After falling over 15% this year, emerging market (EM) currencies rallied in October roughly 5% as market probabilities of a 2015 Federal Reserve (Fed) hike retreated, and the multi-year US dollar rally stalled as a consequence.
The stronger dollar and weaker EM currencies have moved in lockstep essentially since the “taper tantrum” (which refers to the sell off in stocks and bonds after the Fed first warned it was winding down its quantitative easing program) of May 2013 when the eventuality of higher US rates began to take hold.
EM currencies on average have fallen about 40% since that time, so it is difficult to argue that a modest Fed rate hiking cycle has not been well anticipated in this asset class.
Some derivatives of the stronger dollar, like weaker global commodity prices, also helped to sour sentiment.
Real exchange rates in EM in general are at levels not seen since the early part of this century, and countries that have historically run substantial current account deficits are seeing those shrink meaningfully as a consequence of both weaker currencies and lower import levels as growth has stalled.
Dollar-denominated debt a different story
The dollar-denominated side of the EM debt asset class has been a much different story. Year-to-date both corporate and sovereign debt indices are up about 3%.
Even with the positive returns and an October rally, spreads to US Treasuries remain generally wider than historical averages by at least 50 basis points.
Market anticipation of lower rates for longer globally leave emerging markets as one of the last outposts available for generating income.
The stability surrounding dollar bonds even as fundamentals in larger countries in the asset class deteriorated should continue unless a more negative shock to the asset class materialises.
Though the divergence in global monetary policy in developed markets has generally meant a strong US dollar and weak EM debt, this pattern could change going forward if US economic data continues to be unsupportive of more than a few token rate hikes even if the Fed proceeds in December.
Diverging global monetary policy
A more aggressively dovish European Central Bank, potentially more stimulus from the Bank Of Japan, and continued sporadic easing in China suggests that global liquidity will remain high.
The demonstrably lower concern over a China hard landing is supportive to the asset class.
One measure of liquidity—the change in foreign reserves across the asset class—has shown some recovery as risk appetite rallied this month.
Additionally, debt issuance has picked up across an array of countries this month, easing re-financing risks.
So, while a first Fed rate hike being more fully priced in for December may temporarily cause a return of market jitters, we believe the small likelihood of an extended hiking cycle and substantial global liquidity from other developed central banks lower the odds for a relapse into systemic EM concerns.