When emerging market (EM) central banks were aggressively easing during the heart of the pandemic, they were counting on the “reach-for-yield” dynamic that played out during much of the previous business cycle to continue to support their currencies and yield spreads. With the benefit of hindsight, we know that things generally went according to plan, with most EM currencies performing well.
This year has been a different story, with U.S. yields turning sharply higher and reflation expectations putting upward pressure on EM yields and downward pressure on some EM currencies. Normally, reflation isn’t negative for EM because it typically comes in a risk-on environment that leads to U.S. dollar weakness and tight yield spreads. This is especially true if reflation is led by China, as this leads to higher commodity prices, which is supportive of commodity-producing EM economies.
The concern this time around is that the U.S. is driving reflation expectations. This is due to unprecedented fiscal stimulus, the Federal Reserve’s commitment to its new flexible average inflation targeting (FIAT) framework and vaccine distribution outperformance. As a result, expected U.S. economic outperformance has supported the dollar and steepened EM yield curves. In response, central banks in Brazil, Russia and Turkey all raised rates by 75 basis points (bps), 25 bps and 200 bps, respectively. The Bank of Mexico stayed on hold, contrary to prior expectations of a rate cut.
In response to rate hikes, Turkish President Recep Tayyip Erdogan replaced Turkey’s central bank governor. Certainly, Turkey is not a representative example, but it wouldn’t be surprising to see political pushback to rate hikes in other countries as well as higher rates hinder an economic recovery that has barely begun.
However, there are also costs to not hiking. EM central bankers often do not get the benefit of the doubt from markets when it comes to their ability to bring down inflation to target. Against a backdrop of very easy monetary policy, any signs of inflationary pressures would hurt EM currencies and lead to a negative feedback loop — a weaker currency means higher import prices, which means higher inflation, which means a weaker currency. This cycle between inflation and exchange rates is made worse because EM currencies don’t benefit from reserve currency demand like the U.S. dollar does.
Moreover, the current rise in U.S. yields is just the first step in a three-step process through which Fed normalization will impact EMs. The second step will be the actual tapering of asset purchases followed by the third step of realized rate hikes. Unfortunately for EM central banks, each step gets progressively more challenging.
But there are also reasons for optimism over the medium term. For now, Fed hikes are a distant concern, and increased vaccine distribution later this year should be a tailwind to the EM recovery, limiting the extent to which U.S. outperformance impacts EM assets. Of course, it should also be noted that differences among EMs are as important as the common themes discussed above. Countries with low debt/GDP ratios, large foreign exchange reserves, positive vaccine distribution outlooks, and proactive and credible central banks should do better. While credibility is hard to quantify, it is a function of historical success in controlling inflation and central bank independence. As such, Turkey is an obvious concern, as is Brazil, due to its high debt/GDP ratio and COVID-19 situation. Conversely, most Ems in Asia should find themselves in a favorable position. | |
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