News that the US Federal Reserve (Fed) is on course to tighten policy fairly aggressively, including shrinking its balance sheet, is instinctively worrisome for investors in emerging markets. The economic consequences of quantitative tightening (QT) appear manageable, but it is likely to be a headwind for the performance of markets.
Why concerns over policy tightening have been rising
Expectations for Fed tightening have continued to grow in recent weeks. These have been fanned by the hawkish tone of the minutes from the December meeting of the Fed’s rate setting committee, the Federal Open Market Committee (FOMC).
Not only did voting members raise the possibility of raising rates sooner than had previously been expected, but reducing the size of the Fed’s balance sheet was also on the agenda. Short dated bonds could be allowed to mature or the Fed could become an active seller.
What more aggressive policy tightening means for EM
The prospect of QT is likely to have raised a few eyebrows within the emerging market (EM) investment community. After all, the performance of EM economies and assets tends to be sensitive to gyrations in US dollar liquidity, and markets generally suffered the last time that the Fed shrank its balance sheet in 2018.
On the economic front, perhaps the most obvious way that tighter global dollar liquidity could hurt EM is through the balance of payments. If QT dampens dollar liquidity it could expose EM that rely on inflows of foreign capital to fund external deficits, forcing a reduction in imports and ultimately a deceleration in economic growth.
Why US Treasury yields are important to monitor
There is actually very little direct relationship between changes in the size of the Fed’s balance sheet and capital flows to EM. As the chart below shows, aside from the period around the global financial crisis, capital flows and the Fed’s balance sheet have often moved in opposite directions.
That probably reflects the fact that the Fed typically expands its balance sheet during times of crisis and has been very cautious about reversing course.
Any transmission of QT to EM activity would be more likely to come through the Treasury market.
Whereas the Fed’s balance sheet bears little resemblance to capital flows to EM, there is a clear relationship with changes in Treasury yields. Should QT result in much higher Treasury yields, EM inflows and growth could suffer.
The macroeconomic risks may be contained, but is there a risk to EM asset prices?
A year ago we argued that EM was less vulnerable to an increase in Treasury yields than in the past, given that flows to EM had been systemically weak and external positions were in relatively good shape. Higher energy costs are likely to drive a deterioration in the external positions of those EM that rely in imports of natural resources. However, beyond a handful of small EM such as Romania, Egypt and Turkey, solid external positions continue to offer a buffer to tighter financing conditions.
If the macroeconomic consequences do not appear particularly worrisome at this juncture, the same cannot necessarily be said for EM asset prices. After all, the last time the Fed shrank its balance sheet in 2018 there was a wobble across EM financial markets.
Again, the relationship between gyrations in the size of the Fed’s balance sheet and EM markets in not particularly convincing. While QT coincided with a sell-off in EM assets – depicted in the chart below by changes in the spreads on US-dollar denominated government bonds – there is not a good relationship between the two.
EM investors should be more focused on global central bank liquidity
Instead, a broader measure of global central bank liquidity has a far better relationship with movements in EM asset prices. Here we define the global balance sheet as an aggregate of the Fed, European Central Bank, Bank of England, Bank of Japan, People’s Bank of China, Swiss National Bank and Sweden’s Riksbank, in US dollar terms.
Either way, our projections indicate that global central bank liquidity will begin to shrink in 2023. While not the only driver of performance for markets, that will probably be a headwind for EM assets. US dollar denominated bonds have historically been most sensitive to QT, but equities and currencies will also be vulnerable.