Fed plus hawkish – How would EM react?
Natalia Gurushina, Chief Economist, Emerging Markets Bond Strategy, Van Eck Partners Company
The question of the day is how EM central banks – and EM assets – would react to the more hawkish US Federal Reserve. Past experience is encouraging, but tight emerging market spreads and negative real policy rates are cause for concern.
Global rates increased after the U.S. Federal Reserve minutes confirmed hawkish stance, raising possibility of faster political normalization. This morning, Fed Funds Futures estimate a 75% chance of the first rise in March, followed by at least two more during the year. Emerging market (EM) fixed income securities have performed well over the past two tightening cycles in the United States. a sharp rise in US real rates (see table below) is a major risk in the short term – particularly in a context of tight sovereign and corporate spreads in EM.
A big question right now is Can emerging market central banks decouple from the Fed in the current tightening cycle? Many of them have been anticipating rate hikes in 2021 in response to rapidly rising inflation, and the consensus is that emerging market rate hikes have peaked in Q4-21 or will peak in Q1-22. . Nominal policy rates are already above the pre-COVID level in EMEA and LATAM – the problem is that real policy rates are still very negative in many countries (even adjusted for expected inflation), which may necessitate longer tightening cycles in emerging markets if inflationary pressures prove to be more persistent.
Regarding short-term inflationary pressures, we are closely monitoring developments in Kazakhstana, which is a major producer and exporter of oil and gas. The country crosses a major episode of political instability, with widespread social protests that turned violent and resulted in a 2-week state of emergency. The Kazakh government has also asked military assistance from the Russian-led alliance from several former Soviet states. Internet shutdowns affect the flow of information and the situation on the ground is extremely fluid. Stay tuned!
Chart preview: Sharp rise in US real rates – a short-term risk for emerging market assets
Source: Bloomberg LP
PMI Index – Purchasing Managers: economic indicators derived from monthly surveys of private sector companies. A reading above 50 indicates expansion and a reading below 50 indicates contraction; ISM – PMI Supply Management Institute: ISM publishes an index based on more than 400 surveys of purchasing and supply managers; both in manufacturing and non-manufacturing industries; CPI Consumer Price Index: an index of the change in prices paid by typical consumers for retail goods and other items; PPI – Producer price index: a family of indices that measures the average change in selling prices received by domestic producers of goods and services over time; PCE inflation – Price index of personal consumption expenditure: a measure of US inflation, which tracks changes in the prices of goods and services purchased by consumers throughout the economy; MSCI – Morgan Stanley Capital International: a US provider of equity analysis tools, fixed income securities, hedge fund market indices and equity portfolio analysis tools; VIX – CBOE Volatility Index: an index created by the Chicago Board Options Exchange (CBOE), which shows the market’s expectations for 30-day volatility. It is constructed using the volatilities implied on the options of the S&P 500 Index .; GBI-EM – JP Morgan’s Government Bond Index – Emerging markets: comprehensive emerging market debt benchmarks that track local currency bonds issued by governments in emerging markets; EMBI – JP Morgan Emerging Markets Bond Index: JP Morgan index of sovereign bonds denominated in dollars issued by a selection of emerging countries; EMBIG – JP Morgan Global Emerging Markets Bond Index: tracks the total returns of external debt instruments traded in emerging markets.
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