Emerging market economies from Turkey to Indonesia were rattled last year as investors worried about the impacts of the U.S. Federal Reserve tapering their quantitative easing (QE) program. Now a similar story is playing out following the US Federal Reserve’s potential benchmark interest rate hike.
Earlier this year, investors returned to emerging markets as they came to believe that developed-world central banks wouldn’t be as quick to pull back on their easy-money policies. This resulted in many emerging market currencies rebounding and strengthening against developed market currencies. However, the past couple of months have witnessed the opposite trend as the US Dollar Index has strengthened for 10 consecutive weeks; the dollar’s longest rally since the index was created in 1973. Why is this happening, and what does it mean for emerging markets?
Interest rates and why the US dollar is surging:
- Geopolitical risk: As the marketplace scrutinizes and digests information from the Federal Reserve, market expectations on when the Fed will raise the benchmark interest rate continues to vacillate. With every new press release and policy statement, the media tries to analyze and devour each word, with often contradictory interpretations (see here and here). What is unanimously agreed upon however, is that the dollar is a safe-haven asset. As global uncertainty surrounding the global economic recovery increases (hello, downward revisions from the IMF), the dollar’s status (particularly in the form of US government bonds) as a low-risk asset becomes more secure.
- Interest rate expectations: The market fully anticipates the Federal Reserve to begin interest rate hikes in mid-2015 (for that matter so does the FOMC). What has become glaringly obvious in recent months however is that the pace of hikes and the terminal rate (the place where the Fed stops raising the Fed Funds rate) are in serious question. FOMC participants are now not only projecting simply the midpoint of the range of the fed funds rate at year-end, forward guidance based off discrete data is becoming less important. This vagueness from the US central bank is leading to increased market uncertainty around Fed policy decisions. Market perception seems to indicate a more dovish position, and for good reason. The Fed cannot afford to hike rates too quickly as they own a huge chunk of bonds. If interest rates were to be hiked quickly the value of the Fed’s holdings could plunge, prompting massive losses and jeopardizing the annual remittance to the US treasury. Nonetheless, the possibility of shrinking interest rate differentials between the United States and other economies is changing the risk-return payoff for investors, and leading to a surge in the US dollar.
What does this mean for emerging markets? (Hint: it’s not good)
- Commodities plummet: Many commodities (including petroleum) are priced in US dollars. When the value of the dollar goes up, it will take less dollars to buy commodities, thereby reducing the price. For many emerging market economies, commodities are still the breadwinners. When the value of their commodity exports decreases, it can put a strain on already cash-strapped governments and consumers and lead to deteriorating growth.
- Capital flow volatility: Any increase in global risk aversion or change in expectation of policy from central banks has massive implications for portfolio flows to emerging markets. According to the Institute of International Finance, a 100 basis point upward shift in expectations of future US policy interest rates is estimated to reduce capital flows into emerging markets by $56 billion in that same month (equivalent to .33% of total emerging-market GDP). Similarly, emerging-market portfolio flows are highly sensitive to global risk aversion. In a proxy for global risk (US BBB-rated corporate bond spread over treasuries), an increase in this spread by 100 basis points is associated with a reduction in emerging-market portfolio flows of $71 billion (or .41% of EM GDP) during the same month. A reduction in capital inflows to emerging markets not only leads to amplified emerging market currency volatility (usually depreciation), but also hampers the ability of many economies to achieve their spending goals as they are dependent on that foreign capital for growth.
As ambiguity around the Federal Reserve policy decisions becomes more commonplace, the global economy better get used to uncertainty. Growth depends on it.