As central banks prepare the ground for a retreat from years of monetary easing, the tremors are resonating around the world, particularly for investors in emerging markets.
Memories of the rout sparked by the 2013 taper tantrum across EM remain relatively fresh. As leading global sovereign bond yields have risen sharply in the past two weeks, so the strong performance of EM asset prices seen this year faces a major test.
As investors await details of the pace and size of QE retrenchment from the European Central Bank and other G10 policymakers, the 10-year German Bund yield has more than doubled towards 0.60 per cent since late June, climbing to its highest level in 18 months.
The era of continuous monetary stimulus has changed investor behaviour, says Alberto Gallo of Algebris investments. “ . . . They became eager to take on more risk, knowing that central banks would keep QE measures going at the first sign of market turbulence”, he says. Hence, the withdrawal of stimulus “may result in a return of volatility”.
Crucially, moves in long-dated rates, such as 10-year German Bunds, tend to matter more for EM than front-end rates, says Kamakshya Trivedi, head of forex and EM strategy at Goldman Sachs. “It is the speed of the moves that will be most concerning,” he says.
No matter signs of market volatility are picking up as yields climb, Mr Trivedi adds. ‘”We think EM could be relatively resilient to these shocks.”
That is because he and other analysts as well as many investors believe EM has less to fear this time around. The global backdrop is altogether more secure than it was in 2013.
Global growth looks strong, EM financial structures are in better shape and their balance sheets have by and large been cleaned up, helped by rising foreign participation in local currency debt markets. If EM economies are less dependent on external financing to service current account deficits, that helps to cushion the impact of falls in their currencies.
Above all, the US dollar remains subdued. Rising global bond yields are spurring broad strength among currencies versus the dollar. That is a relief for EM, given how government and companies have raised a lot of dollar-denominated debt. A rising dollar makes it expensive to service these debts.
Underpinning this sunnier outlook is the pick-up in global trade. “The appetite of investors has been crucial. Global trade, financial conditions and capital flows have been the demand drivers, while oil and the dollar have faded in the background,” says Valentijn van Nieuwenhuijzen, head of multi-asset investing at Dutch-based NN Investment Partners.
Furthermore, political crises in the UK and the US have already influenced investor sentiment. “We downgraded EM after the Trump election,” says Mr van Nieuwenhuijzen. “It was seen as a negative feedback.”
But when investors understood these were political rather than economic crises and non-contagious, EM’s attractions rose and markets realised EM would be in a “very good position to benefit from a rebound in global trade”.
Still, there are plenty of risks ahead for EM, with the imminent return of volatility the biggest. Investors expect any announcement of QE tapering from the European Central Bank or a start date for the Federal Reserve shrinking its balance sheet, possibly in September, will trigger increased market turbulence.
EM looks a different prospect when volatility rises. One guide of EM confidence is activity in the carry trade, where investors borrow assets at low interest rates to invest in their equivalent assets where rates are higher.
“Investors get confident when the carry-to-volatility ratio is high, so we should expect there to be less confidence if volatility goes up,” says Lisa Scott-Smith at Millennium Global.
Shifts in dollar expectations could also affect confidence in EM. Indeed, says Mr Trivedi, what the Fed says and does matters much more to EM than any other central banks.
A rising dollar has knock-on effects on commodity prices, a big factor in the economic health of many EM countries. “When the dollar is strong, the dollar is strong relative to the rest of the world, and that tends to be a sign that commodity prices are more subdued,” says Paul McNamara at GAM.
Investors will also need to beware the latest rise in US real yields, which is again weighing on EM currencies. The speed of the increase in recent weeks is “of the magnitude that previously pressured EM”, says Ms Scott-Smith, referring to three occasions since the US election when EM currencies came under pressure.
On those occasions, the 10-year real yield peaked and reversed and EM recovered, “so the sustainability of the rise in real yields will be important to gauge if this is more than simply a short-term washout in EM or something more worrying”.
For the time being, investors are not showing any major signs of alarm about the QE retreat. The evidence thus far in currencies and fixed income is promising.
The “relentless rise” of US interest rates has put EM under scrutiny, says Neil Mellor at BNY Mellon, but the resilience of risk appetites to tapering means there is “the possibility at least of a further, sustained period of interest” in this segment of the market.