THE taper tantrum was brutal, but rising rates do not have to mean lousy performance for emerging markets.
As investors look to the possibility of rising official interest rates in the United States and Britain in the coming year their expectations are coloured by nasty memories of 2013’s taper tantrum, when bumbled communications by the Federal Reserve caused Treasury yields to spike and emerging markets to suffer.
Asset performance was both volatile and very poor, particularly among emerging market countries like India and South Africa which need to attract capital flows from abroad.
But much depends on why rates are rising, rather than just the direction.
“Higher interest rates and exit from monetary stimulus in major advanced economies when led by stronger growth prospects produce good spillovers,” according to International Monetary Fund economist Hamid Faruqee, one of the authors of a report this week on the potential impact of interest rate normalisation.
“Interest rates tend to rise elsewhere. But they are lifted by a rising tide of economic activity at home and abroad. Another positive development is that trade and capital flows tend to strengthen.”
That’s in contrast to last year, which was more of a money shock, in which interest rates rose more rapidly than can be justified by the performance of the real economy. Those sorts of tightenings, of which the taper tantrum is just the latest example, are characterised by tougher conditions in capital markets, outflows of capital from weaker emerging markets and lower overall cross-border flows.
In other words, if rates rise because a strong recovery dictates they should, emerging markets will do just fine. If, however, rates go up to control inflation without a recovery or to tamp down speculation, then watch out.
Janet Yellen’s clearly enunciated policy of not using monetary policy to control risk taking, relying instead on macroprudential tools like regulation, is great news therefore for emerging markets. Or at least will be so long as that remains policy.
Of course any transition from an unprecedented situation bears risks, and surely emerging markets will be highly dependent on how well the Fed manages the transition away from zero interest rates and the eventual runoff of its massive balance sheet.
And while last year’s tantrum is seared into investors’ memories, the recent history of Treasury yield spikes and their impact on emerging market currencies and interest rates is relatively benign.
Analysts at Societe Generale looked at the 16 instances since 2000 in which long-term Treasury yields spiked by more than 50 basis points in three months or less and found that a basket of emerging market currencies weakened by only 0.4% on average.
Spikes had a bigger impact on the oil price, which rose by nearly 9% on average, which in turn might hit emerging markets.
“A marked increase in oil prices has historically been associated with a negative impact on emerging markets. It therefore makes sense to keep an eye on the oil price action,” Socgen analysts Benoit Anne and David Hok wrote in a note to clients.
In some ways the Treasury spike which might tell us most about the next year was the one which happened in 2004, when the market correctly anticipated a tightening cycle after a change in Fed language in its March policy statement. That drove a 15.5% spike in oil and hit some emerging markets hard, particularly Brazil and Turkey.
Overall, though, many emerging markets recovered their previous levels in several weeks and good global growth prospects helped to underwrite a strong rest of the year.
For 2004 to trump 2013 the conviction that the Fed and BoE will hike needs to be accompanied by stronger evidence that they are doing so for positive reasons. Wednesday’s Fed statement was more reassuring than encouraging, highlighting several reasons, notably weakness in housing and labour markets, which might justify a delay in rate hikes for some time.
That focus on labour markets, particularly on wage growth, makes Thursday’s news that the employment cost index rose at a brisk 0.7% clip in the second quarter very significant for emerging markets.
That gain, the fastest rise in US employment costs since 2008, could be an early sign that wages are finally improving.
Several more months of that and we could be looking at a rate-hike cycle which is good news for the global economy and emerging markets.
If that doesn’t arrive, emerging market investors had better hope that financial market bubbles don’t force the Fed into hiking despite sluggish growth. – Reuters