As expectations continue to grow for the Federal Reserve to wind down its stimulus package for the economy, emerging-market debt is beginning to sell off. Does this sell-off show us signs of what is in store for the S&P 500 (SPY) soon?
Since May, the iShares MSCI Emerging Markets ETF (EEM) has felt the pinch of the anticipated tapering. From a high of just over 43.5 in early May, the emerging market stock had slid down and presently is trading at about 37.25 in a four-month bearish pattern.
There were a lot of investors pouring money into emerging market "fixed income instruments" and currencies as they borrowed against the Japanese yen and US dollar, so they could buy assets in countries with higher interest rates.
Investors were able to profit because of the difference in interest rates when they borrowed currencies that have low yields and use them to buy assets that are nominated from higher-yielding counterparts.
Here's an example: the Australian dollar has been a high yield currency. Investors would buy this dollar and then sell a low yield currency such as the US dollar. The Australian dollar was expected to gain value on the US dollar while the investors also collected the interest rate differential between the two. As the Australian central bank began to cut rates, the value of the dollar dropped significantly as compared to the US dollar.
Fears began to surface when Bernanke spoke in May about the beginning of a tapering process getting closer. So one can see how the drop in the EEM coincides with Bernanke's message. Investors reacted; perceiving more risk and volatility as these "carry trades" underperformed significantly. This shift in policy by the Fed tended to make countries that have sizable "account deficits" susceptible to the weakening currency.
These emerging-market trades have fallen off the plain of popularity and no one knows if they can recover. As emerging market economies continue to show signs of weakness, returns will also continue to be weak. This all started with an announcement of policy shift from the Feds. Once everything starts being put in the motion, I would assume these emerging market returns will continue to become invisible and money will dry up.
So what does this mean for the stock market and stocks as a whole?
US equities and the "currency carry trade" have had a relationship of moving together. Since the currency carry trade has taken the lead role in unraveling, I am wondering if our current stock market rally will follow suit.
On this Yahoo finance chart, when we compare PowerShares DB G10 Currency Harvest (DBV) with the S&P 500 (SPX), they have pretty much moved in lockstep until May 2013. Now the question arises whether or not the S&P 500 will chase after the DBV.
Before Bernanke spoke in May, many investors were banking to make a lot of money on the emerging markets fixed income instruments and local currencies but attitudes shifted quickly after the announcement. Investors were now debating why their money should even be in emerging-market debt. Even though the US stock market has not followed in the emerging market downfall, it would be wise to consider some signs to watch in the market.
The philosophy of the "carry trade" parallels buy-and-hold strategies in equities. An investor may buy a stock looking for capital gains as the price of the stock increases and at the same time, receiving dividend payments. A "carry trade" looks to gain value from the movement of the currency while collecting income from the rate differentials.
Since the two have moved in the same patterns, should we be concerned about the direction of the market in the near future?
The recent rise in US bond yields could put a damper on economic growth and corporate profits which would potentially weaken stocks. This is only one scenario though. If the economy continues to look healthy, the stocks may rally which would naturally encourage investors to put money in equities instead of fixed income investments.
Even though I would still say stocks are in a bullish trend, I would take note of the observations I've made above. It would not be surprising to see a short-term correction take place soon. The observations and trends that I am making do not create a solid argument for a correction, but definitely should raise the eyebrows of investors just to be aware.