US rates & emerging markets
16 October 2018
The Federal Reserve lifted short-term interest rates for the third time this year, giving a very positive tone for the US economy, increasing to probably more than 3% this year.
Unfortunately, the emerging markets route is not “made in America”. The tightening cycle in US rates put upward pressure on the US currency. Some countries in EM, which need to borrow in US Dollars, should have larger external imbalances with higher costs of funding. Turkey, Argentina, and South Africa are examples. EM economies, that have suffered the most, are those with weak fundamentals, internal and external deficits, high inflation and a heavy reliance on external borrowing. One thing is different this time compared to other hiking rate cycles such as in 1994: the correlation between the Fed funds rate and EM risks is not that tight. The Fed’s current path for 2018 and 2019 has not changed significantly, from what it projected in March 2017 (0.25% higher than projected earlier) and markets have had the time to digest this issue for some time anyway. Moreover, emerging economies are fundamentally in better shape than they were before: EM economies have adopted free-floating currencies and have higher levels of reserves, lower inflation and better debt ratios in many cases.
China has become a bigger driver on EM markets’ risk. As the biggest buyer in Asia, China’s behavior regarding imports from others emerging markets can influence global trade significantly. Trade tensions are, for sure, another risk factor for EM assets. The idea that growth in China could be slower in the coming years is just problematic for EM countries as a whole.
The combination of various risks added to political uncertainty/concern have certainly triggered EM volatility and EM risk aversion this year.
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