Emerging markets tinder, Fed match

Being an emerging market central banker during a cycle of U.S. interest rate rises is no fun, none at all.
The experience of emerging market investors when the U.S. hikes is more mixed: good news if increases coincide with a rising economy but bad if they are intended to tamp down speculation.
This time round investors and central bankers look to be in the same miserable boat.
A new report from the Bank for International Settlements expressed doubts about how emerging markets will fare as U.S. rates rise and also showed how little independent control their policy-makers actually have.
With a large overhang of debt in major emerging markets like Brazil and China, the past few months of market volatility and falling commodity prices have revealed “fault lines” built up over many years, according to the quarterly report from the BIS, which acts as a central bank of central banks.
Brazil and China, for instance, could well be heading for a banking crisis. Both have seen credit growth way outpace economic growth. China’s credit-to-GDP gap is now at 25 percent, while Brazil’s is nearly 16 percent. To put that in perspective, two thirds of all economies with readings on this measure above 10 percent have in the past experienced “serious banking strains” in the following three years.
That’s the tinder, here may be the match: there are strong correlations between U.S. and emerging market interest rates, stronger than justified by either economic conditions or other risk considerations. This applies not just to market rates, but also to the policy rates set by central banks.
The implication: that market and policy rates in emerging markets will have been artificially suppressed by Fed policy in recent years and may be forced into some reversal of that.
Emerging market central banks, for example, may keep rates low when the Fed is cutting so as not to drive their currencies up and hurt their exporters. On the way back up, it will be all about attracting capital, which has a nasty habit of leaving emerging markets when global conditions tighten.
In other words, emerging market central bankers could easily be forced into economy-choking interest rate rises to keep pace with the Fed.
Watching long rates
A 2014 report from the International Monetary Fund found that interest rate rises in developed economies could be good for emerging market so long as they were done in reaction to strong growth.
Those also brought with them strongly rising trade and capital flows, things we are not now experiencing.
Interest rate rises which get ahead of the real economy, on the other hand, were emerging market poison.
It may pay to watch long-term U.S. Treasury yields for a clue as to which kind of cycle this will be for emerging markets.
In the 10 periods since 1993 that 10-year Treasury yields have spiked by more than 100 basis points, emerging markets equities have done extremely well, according to fund manager Calamos Investments. During those periods emerging market equities have outperformed U.S. large company stocks seven times, usually by a large margin.
But with the notable exception of 2013’s “taper tantrum,” yields rose sharply on 10-year debt because investors expected both growth and a bit of inflation.
Currently, 10-year yields are mired at low levels and have shown very little inclination to rise, either due to rising expectations of Fed hikes or in reaction to market volatility.
So what kind of a hiking cycle are we in, if indeed we prove to get a Federal Reserve increase at all?
These are very unusual times. Not only is the Fed attempting to come up off of virtually zero interest rates, it is doing so during a period of strong cross-currents globally.
The U.S. economy is doing fine. Not the kind of fine it used to do, but certainly not badly enough to justify zero rates and a US$4 trillion Fed balance sheet.
In contrast, not only are things difficult in emerging markets, particularly China, but emerging markets have grown out of all proportion to U.S. growth these past 20 years, making them all the more influential.
So this hiking cycle may be both briefer but also more precautionary than many, motivated not so much by a desire to tamp down speculation as perhaps to give room to cut later.
For emerging markets that may equal short-term losses but less prospect of a rally later.