Investors have been jittery about the impact that the Fed Tapering may have on emerging markets. Many refer to 1994, when the Fed tightening triggered the Tequila crisis. However, the international transmission of the U.S. policy to emerging markets may have changed. In particular, many EM countries are not dependent on external funding, but on the asset side of their balance sheet (commodity exports or holdings of T-notes) of excessive capital inflows. Spillovers of the Fed's actions on Emerging Markets have evolved during the implementation of QE. As can be seen below, the link between risk aversion and the over/under performance of EM MSCI vs. the S&P 500 broke in the wake of QE2.
But Fed exit/tapering is not so much about risk aversion than interest rate risk. Below I focus on the relationship between U.S. Treasuries vs. Sovereign bonds and stock indexes of emerging markets.
An interesting pattern has materialized since the beginning of the year. Unsurprisingly the correlation of U.S. Treasury returns with EM stock returns is still negative: higher rates in the U.S. are generally bad for EM stock returns.
On the contrary, the correlation between U.S. Treasuries and the EMBI (Emerging Market Bond Index) has reached its highest level since the start of the Great Recession. From a period when EM bonds were posting negative correlations with T-notes, the correlation is now turning positive.
This would mean that any Fed tapering translating itself into higher UST yield would trigger lower returns for both emerging market bonds. It seems "normal," but a look back at history may be useful.
The chart below shows that the relationship between returns of both U.S. Treasuries and Emerging bonds is characterized by the existence of different regimes:
- When the Fed tightens, the correlation seems to be positive: sovereign bonds in both the U.S. and EM move in the same direction;
- When the Fed eases, the correlation weakens, hovering close to or below zero;
- The correlation can spike very close to -1 in periods of heightened risk aversion (Asian Crisis in late 1997, Lehman, Greece, and even the Debt Ceiling) when U.S. Treasuries turn into a safe haven.
The recent move towards a positive correlation between those two asset returns suggests that investors fear a scenario "a la" 1994.
This might be a little ill-advised as the Fed has a dual mandate now: dealing with its balance sheet and steering interest rates. The first step of the exit will be a reduction in the pace of purchases, not outright sales of the Fed's portfolio. In addition, the forward guidance will remain and Fed Funds will not be raised before the second half of 2015.
Recent speeches suggest that there is no doubt that the Fed members are willing to start tapering as early as September, insisting that it will depend on the news flow. The reason is linked to some pocket bubbles that are appearing (high yield market), but mostly because the economic backdrop is favorable to a tame reaction of long term yields: low inflation (observed and expected), declined in the net supply of Treasury bonds.
To SUM UP: Even though the correlation switch highlights the growing fear that tapering may have a negative impact on emerging markets, the conduct of monetary policy over the next few quarters suggests that this risk might be overstated. We cannot rule out an overreaction of risky asset classes (stocks in EM and developed countries), but a sharp sell-off driven by higher interest rates in the U.S. is unlikely to occur in the short run.