In our latest Economic and Strategy Overview, we highlighted our expectations for Fed policy tightening. We still think that the current inflation spike in the US will be largely discontinuous. However, the strength of the US economic recovery means we expect fundamental price pressures to increase next year, although policymakers will need to act sooner.
As a result, we expect the Fed to reduce asset purchases under the QE program by the end of this year and begin raising interest rates by the end of 2022. This expectation is also more hawkish than what is currently priced in the markets.
Our view that the Fed will begin to reduce its asset purchases by the end of the year means that policymakers will need to take a decisive hawkish position in the near future. The usual chronology for changes in policy direction is that the Fed should signal (perhaps in September) that it intends to cut purchases later in the year as a final step, before moving on.
Will we see a rerun of the 2013 tantrum?
These prospects quickly bring to mind memories of the notorious tantrum that shook financial markets in the developing world in 2013. Bernanke, the then-Leader of the Fed, prompted a 100 basis point increase in the 10-year Treasury yield after catching investors off guard by telling Congress that asset purchases could be cut. The situation that risk-free rates will yield higher interest rates in the USA has started a capital flight from emerging markets (EM). This influx suddenly exposed large external imbalances, eventually forcing central banks to raise interest rates to defuse financial market volatility.
There is good reason to think that a complete recurrence of the 2013 tantrum will be avoided. Clearly, policymakers are willing to follow Bernanke’s footsteps; expected to be more cautious in approach and connection. The idea that bond purchases will decrease in this midst is no longer foreign to the markets. Indeed, investors are already starting to speculate about the timing. And as we argued earlier this year, the macroeconomic base in EM is a little different: measures of “hot money” flows suggest that foreign investors are not heavy assets. The Covid crisis has also cleared up payments stability problems in more than one economy. Indeed, as the chart below shows, only a handful of EMs have large current account deficits based on short-term financing, which was the basis of the “fragile five” in 2013: Romania, Colombia, Egypt and Turkey.
EM assets can withstand shaking
The beautified fundamentals explain why EM assets were largely able to withstand the sharp sell-off in Treasuries earlier this year, despite market volatility. Yields on 10-year U.S. bonds rose nearly 80bps in the first quarter of this year to 1.72 percent, making it the third-worst sale on a total yield basis in history. But while this caused some wobble in EM financial markets, the magnitude and duration of these losses were small.
For example, the JP Morgan Index of EM currencies against the US dollar fell by only 2.5% mid-February 24 to March 8. While this was only a fraction of the losses experienced in 2013, when the index fell by about 10%, all losses earlier this year were on average offset.
As always with EM, there was a wide distribution in the relative performance of currencies within the JP Morgan Index. Some currencies, such as the Chinese renminbi and Russian ruble, weakened by only 1% against the US dollar, while others such as the Brazilian real, South African rand and Turkish lira fell as much as 8%.
During this period, different events were happening in the countries. For example, the increase in new Covid-19 infections affecting the performance of assets in the Brazilian markets was at the forefront. However, in markets with historically low real interest rates, currency performances plummeted as sales in US bonds began to hit EMs.
Presumably, the Brazilian real, which believes in this model, has started to perform well since the central bank began to aggressively tighten its monetary policy and signaled that it would continue to increase interest rates in the coming months. Real rates in Brazil remain deeply negative, both in real terms and historically, but this hawkish forward drive could partially save the Brazilian currency if the Fed moves.
Which of the EMs are the most fragile?
If markets focus on real rates, it seems that currencies in EM such as Colombia and Peru may come under more pressure. Colombia’s external situation is also weak, with both markets facing political uncertainty. This could force central banks to be more hawkish.
Considering that the positive real interest rate in Turkey, the stability of payments is relatively weak, and President Erdogan has invited an early interest rate cut, it does not seem likely to save the lira completely.