Snapshot

Why this is no Taper Tantrum 2 for EM bonds


Some financial markets have reacted as if Federal Reserve (Fed) Chair Jay Powell rang the bell for tapering of easy financial conditions at the 16 June policy meeting. Investors have naturally dusted off the playbook from the last episode, the notorious “Taper Tantrum” that began in May 2013.

Whether this is correct or not, it is necessary to start to think about the implications for markets. It is a particularly key consideration for emerging markets (EM), which were hit hard by the Taper Tantrum.

EM are in much better shape for this taper than they were in 2013. Ironically, this is partly because of the damage done by the 2013 episode, as currencies were driven to extremely cheap levels, which led to much improved trade balances.

We see three key positive factors for EM economies today, which weren’t there in 2013:

  • Real exchange rates: this measure of currency value (comparing the cost of the same goods in different countries) is much less stretched across the asset class compared to 2013. Consequently, external accounts (value of exports minus imports), are much healthier, which means EM generally have less need for, or exposure to, foreign portfolio flows. This makes the probability of dramatic declines in currencies, such as were experienced in 2013-2015, low.
  • Real interest rates: EM central banks have already begun to tighten interest rates to respond to higher inflation, giving them a head start in moving real interest rates (policy rates minus inflation) towards or beyond zero. The relative attractiveness of EM real interest rates versus developed markets should persist, drawing capital to the asset class.
  • Limited scope for dollar strength: The dollar should rise in value as market fears about higher rates increase. That will no doubt lead to higher volatility for EM currencies until there is more clarity on the timing of tapering. Unlike 2013, however, the dollar’s rise will likely be curbed by far larger external deficits and much larger fiscal deficits. 

EM-real-effective-exchange-rate-2013-npw.png

EM-current-account-balance-2013-versus-now.png

EM-real-rates-2013-versus-now.png

The parallels between then and now

On 22 May 2013, Fed chair Bernanke made clear that the Fed was starting on a path towards tapering bond purchases, and ultimately tightening monetary policy: “If we see continued improvement and we have confidence that that’s going to be sustained, then we could in the next few meetings….take a step down in our pace of purchases.”

On 16 June 2021, chair Powell said that “reaching the conditions for lift-off will mainly signal that the recovery is strong and no longer requires holding rates near zero”.

In both cases, the market perceived the statements as signaling a meaningful policy change. But, as 2013 showed, the tapering path can be long and winding. In 2013 it wasn’t until the 18 December that bond buying was actually reduced with the first rate hike announced in December 2015.

The similarities in statements and starting points would suggest that there will be at least some parallels in terms of asset price reactions between the two episodes.  

Initial market responses, on the other hand, suggest not. The 2-year US Treasury yield has barely changed since the June announcement to end-July. By contrast, it rose 10bps from the Bernanke announcement in May 2013 to the end of the following month.

EM bonds and currencies have also shown a more resilient initial response. The spread on EM high yield corporate bonds is little changed, compared to a clear negative move in 2013, and EM currencies have dropped slightly, but by much less than in 2013. 

What happened to prices in 2013?

The tapering experience in 2013 was preceded by zero interest rates for over four years and quantitative easing, following the global financial crisis. After that long period of rates stability and market recovery, the prospects of a change, however gradual, induced significant market moves. This was also uncharted territory for investors.

The Barclays Aggregate Bond Index was down -2% in 2013, its first negative return since 1999, though it recovered to produce a 6.6% total return for the next two years. Long dated treasuries plummeted to produce a -13.4% return in 2013. Commodities tumbled -7.6%.

EM underperformed in the tapering “era” of 2013-2015. The sovereign JP Morgan EMBI Global Index fell -5.3%, recovered to 7.4% in 2014, but had an anemic 1.2% return for 2015. EM equities, as measured by the MSCI Emerging Markets Index, fell -3.7%, -3.9% in 2014 and 16.2% in 2015, while major US indices were positive.

Local currency investors endured a similar performance with 2013-2015 returns of -9%, -5.7% and -14.9%. A central driver for EM performance, the dollar, was essentially unchanged in 2013 before soaring 15.9% in 2014 and a painful additional 6.4% in 2015.

What happens next?

We think the charts above show that there are indeed some parallels in the market’s reaction to the perceived change in direction towards tapering, however far away that might be. So some pain for EM assets relative to developed market assets seems probable for some period of time.

But the extent of that pain is likely to be limited given the fundamental differences in the asset class between now and then. Even though we are eight years removed from the last Fed taper and tightening cycle, the significant damage caused by that episode ironically means EM are much better set up to deal with tapering now.

From the Bernanke announcement to the first actual Fed rate hike in December 2015, the currency-only return of the EM local currency bond index totaled -19%. That currency carnage cleared the way for a substantial improvement in external accounts as the cheaper currency levels made exports more competitive. At the same time, because of a reserve of central bank credibility and structurally lower inflation volatility, fairly modest tightening cycles proved effective in controlling inflation.

Today, real effective exchange rates are cheaper, external accounts are more solid and inflation is broadly lower, as shown below. Additionally and perhaps most encouragingly, central banks in key countries like Russia, Brazil and Mexico have already hiked interest rates to deal with a rise in inflation. Early signs are that this inflation bump is likely to be short lived given still wide output gaps. If so, this will make EM real interest rates even more attractive. Importantly, foreigners’ share of local debt ownership is now much lower than it was in 2013.

For all of these reasons it seems unlikely that EM asset prices will fall to the same extent as previously. And it should be pointed out that if the Fed shows more patience in the tapering cycle or even revises their outlook due to slower US growth, EM assets would be well poised to significantly outperform.