Emerging market investors firmly focus on central bank decisions
Investors in emerging market assets always carefully monitor statements by the US Federal Reserve. This week, the focus is particularly sharp.
No policy change is expected from the Fed on Wednesday. But the potential for inflation to rise as the US economy emerges from the coronavirus crisis has stumbled the country’s government bond market, dragging emerging market bonds down as well.
Now, any sign that the Fed may even consider pushing forward its distant plans to hike interest rates could make a tough year for emerging markets even more difficult, and potentially push EM central banks to raise rates as well. .
“This week is going to be huge,” said David Hauner, head of emerging markets strategy and economics at Bank of America. “The Fed meeting has been one of the most important in a very long time.”
The central bankers of Brazil, Turkey and Russia also meet on Wednesday, Thursday and Friday, respectively. Coronavirus-scarred economies mean they would rather maintain their stimulus, Hauner said. But any hawkish Fed tilt would likely drive the dollar higher and hurt emerging currencies, exacerbating the risk of accelerating inflation. “How much leeway they have depends on the strength of the dollar and what’s going on in Washington,” he said.
“What will really matter for MS is whether there is a signal [from the Fed] that rising yields have taken a head start, ”said Jonathan Fortun, economist at the Institute of International Finance.
“If such a signal is sent, it would help EM immensely. If, on the contrary, there is a message that the rise in yields is good and justified by better growth in the United States, then things get trickier. “
U.S. government bonds have weakened sharply this year, as better immunization news and the Biden administration’s promise of huge fiscal stimulus have raised hopes for a quick U.S. recovery . Bondholders fear that rapid growth will lead to higher inflation, eating into the fixed income streams that bonds provide.
As bond prices fell on liquidation, the yield on 10-year U.S. Treasuries fell from 0.9% at the end of 2020 to 1.6% this week, returning to levels seen last. times before the pandemic.
This erodes the appeal of high yielding emerging assets, which are also seen as riskier. After the U.S. rate hike accelerated in February, investors also began shedding emerging market assets, with cross-border portfolio flows turning negative in the first week of March for the first time since October, according to IIR.
The impact was most marked on the bond markets. The JPMorgan benchmarks for emerging local currency and foreign currency bonds have fallen sharply over the past month, bringing losses this year to around 5 percent.
All of this puts pressure on emerging market central banks. Brazil, for example, has cut its policy rate aggressively in recent years. But with short-term rates now negative after inflation, the currency came under pressure and long-term yields rose as investors demanded better returns.
Analysts say Brazil’s central bank will have no choice but to raise rates at its meeting on Wednesday, even as death rates from Covid-19 remain alarming. Markets are expecting a half point hike from the current 2 percent key rate, and further hikes are expected to take the Selic rate to 4 percent before the end of the year.
This threatens to add to the fiscal pressure on the government, as its spending during the pandemic has already raised public debt above 100% of gross domestic product, according to IIR, and higher interest rates will rise. borrowing costs.
Likewise, Turkey’s central bank “has virtually no margin for error,” says Phoenix Kalen, emerging markets strategist at Societe Generale, and will be forced to raise its key rate by a full percentage point on Thursday to 6 p.m. %.
“Previously, we expected him to keep the rate unchanged, but now we expect 100 basis points, given the instability of financial markets and the vulnerability of Turkey,” she said. declared.
Russia is not expected to raise its key rate on Friday, but it should adopt a more hawkish tone and set the stage for a rate hike as early as next month.
Some investors expect emerging assets to withstand the pressure of rising US rates as long as other conditions remain favorable. Benjamin Melman, CIO of Edmond de Rothschild Asset Management, said global liquidity, fueled by trillions of dollars from the Fed and other central banks during the pandemic, was more relevant than the yield on US 10-year bonds .
“There is no discussion of the reduction [that liquidity]”He said,” So it will be a positive wind for emerging assets. “
BofA’s Hauner said that even if short-term volatility eases, there is little chance of avoiding a rise in U.S. interest rates beyond 2023 based on current projections. This put pressure on countries like Brazil to get their debt under control.
“As an emerging market, you absolutely have to get your house in order by then,” he said. “This is the maximum time you have.”