Positive U.S. Real Yields Add To Toxic Emerging Markets Cocktail
(Bloomberg) — Emerging market fund managers’ long list of worries threatens to expand further, with positive real yields in the United States worsening an outlook already clouded by slowing growth and the war in Ukraine.
The first warning shots were fired last week, when the inflation-adjusted rate on 10-year Treasury bills briefly rose above zero for the first time in two years. Although the level did not last long, it marked a turning point – the era of negative yields that caused investors to rush into emerging markets in search of higher yields may be coming to an end as the Federal Reserve is aggressively raising rates.
A sustained and substantial rise in U.S. real yields would be bad news for developing countries, as it generally boosts the dollar and sucks capital out of riskier assets, just as it did in 2008 and 2013. Investors are already preparing to this result: Franklin Templeton is reducing its positions in high-yield debt, while Fidelity International is betting against emerging market currencies and State Street Corp. avoids the local debt of countries with fragile finances.
“As US yields move into positive territory, this is starting to tighten financial conditions and putting pressure on many emerging markets, especially weaker ones,” said Mohieddine Kronfol, Dubai-based chief investment officer for securities at Middle Eastern and North African Fixed Income at Franklin Templeton. “We still think there is cause for concern, from growth to geopolitics, and from inflation to monetary policy.”
It’s not just that positive US real returns are coming, but that they’re coming at a bad time for emerging markets. Inflation in the developing world remained stubbornly high during the second quarter, belying expectations by some fund managers that it would peak by the end of March.
This means that it will be even longer before emerging economies themselves can offer investors positive real policy rates, putting them at a disadvantage to the United States which can. No less than 35 of the 42 countries tracked by Bloomberg have negative rates. Turkey’s minus 47% is the worst real rate in the world.
“We expected emerging market inflation to start peaking in the first quarter, but all bets are off after the sharp rise in commodity prices after the war in Ukraine,” said Guido Chamorro, co- Head of Emerging Markets Division. – foreign currency debt at Pictet Asset Management.
The Riddle of Growth
Investors are also grappling with the impact of the war on food and energy prices, as well as worries about a slowing Chinese economy. Emerging market local currency bonds have fallen around 4% this year, topping the record full-year loss of 3.8% following the 2013 crisis.
“Growth expectations continue to fall and inflation remains at generational highs in many countries, providing a very challenging macro cocktail for investors,” said Paul Greer, fund manager at Fidelity International in London. “Rising US real yields are a headwind for all risk assets and, of course, emerging markets will not be spared.”
Local currency bonds from Turkey, Indonesia and Mexico could be the most vulnerable to a surge in US yields given their persistent fiscal and current account deficits, declining foreign exchange reserves and high foreign ownership bonds, said Emily Weis, macro strategist at State Street in Boston. Every time U.S. yields have jumped more than 50 basis points in a three-month period, bond yields from these developing countries have more than doubled, she said.
Meanwhile, some investors say positive US real rates could herald a potential spike in Fed hawkish policy. For Nordea Investment, now would be a time to get “tactically bullish” on emerging market currencies and sovereign debt, said Witold Bahrke, Copenhagen-based senior macro strategist at the firm.
“I really think that US real yields crossing the zero line is an important step on the way to a peak in the monetary headwinds that emerging market investors face in 2022,” Bahrke said. “Positive real rates would also bring us closer to the peak of Fed ferocity, which is the ultimate condition for risk appetite to stage a meaningful comeback.”
But this remains a contrarian vision for the moment. Most fund managers believe that emerging economies remain at risk of capital flight because there is little they can do to change the equation in the face of improving returns in the developed world. Much of the inflation they face is not their fault, but induced by external factors. Many central banks have already hiked rates to their limit and have little room to tighten further.
So, despite being ahead of the curve, higher U.S. real rates will put more pressure on policymakers to extend their tightening cycles, said Ed Al-Hussainy, senior currency and equity analyst. rates at Columbia Threadneedle Investments. Monetary policy decisions in Russia, Hungary and Colombia will be closely watched this week.
“The most vulnerable assets are low-yielding bonds in Asia and Eastern Europe that are exposed to inflationary fallout from war in Russia and Covid disruptions in China, but have no real buffer of performance relative to the United States,” Al-Hussainy said. . “Latin American commodity exporters that have accelerated their tightening cycles have more of a buffer.”
Here are the main things to watch in emerging markets over the coming week:
- China’s April purchasing managers’ indices due on Saturday will likely show a deeper contraction in activity, underscoring the damage to manufacturing and the services sector from the Covid shutdowns
- China’s industrial profits for March expected to register a decline, according to Bloomberg Economics
- Russia is expected to cut interest rates on Friday as policymakers focus on mitigating the impact of international sanctions on the economy
- Wednesday’s release of activity indicators will reveal how the first full month of war and sanctions has hit the economy
- Hungary will likely hike its benchmark rate by a full percentage point on Tuesday as war in Ukraine stokes inflation
- Colombia’s monetary policy meeting on Friday will also be closely watched, with policymakers divided on the appropriate speed of future rate hikes.
- Turkey’s central bank will release its inflation report on Thursday. The country maintained its ultra-loose monetary policy despite inflation accelerating to its highest level in two decades in March
- South Korea, Taiwan, the Czech Republic and Mexico to report gross domestic product
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