The debate over when the Fed will start to scale back its bond purchases is prompting some investors to turn to assets in emerging markets that are less exposed to a potential surge in US yields.
William Bolley and Fidelity are increasing their holdings of high-yield or frontier bonds that are less sensitive to US interest rates. Meanwhile, Bank of AmericaInvestors are advised to buy emerging market euro-denominated bonds and expect euro yields to remain stable, even if the Fed announces plans to scale back its bond purchases-possibly in September.
These actions were driven by memories of the "downsizing panic" in 2013, when currencies and debt in developing countries fell for about six weeks as the dollar and US interest rates rose in response to the Fed's unexpected suggestion that it would reduce its debt purchases. Friday's jobs data showed strong growth in the United States, indicating that the U. S. economic recovery is on track. The question remains when the Fed will think the rebound is strong enough to start withdrawing stimulus.
"the downsizing panic that has caused US interest rates to soar will begin to attract investors out of most other asset classes, including emerging market assets, and into the US," said Randy Kroszner, an economics professor at the Both School of Business at the University of Chicago and a former Fed board member. "it will be a period of competition for relative quality. That will be the time for people to enter relatively safe emerging market assets and exit relatively risky assets. "
Of course, the sell-off may not be close to what it was in 2013, as developing countries now have better buffers, including stronger current account balances and positive real yields. Improved growth expectations will also support the stock market and some currencies. Still, investors are worried that the Fed could make hawkish surprises in the coming months, which could reverse the momentum of capital inflows into emerging markets.
The topic of code reduction
"emerging markets will have to revolve around the Fed's statement on weight reduction," said Eugenia Victorino, head of Asia strategy at Skandinaviska Enskilda Banken AB in Singapore.
Emerging market bond funds attracted $3.4 billion of inflows in the four weeks to May 28, while equity funds attracted $6.6 billion, according to Bloomberg calculations based on EPFR Global data.
South Korea's KEB Hana Bank plans to start a series of fixed-income conference calls on Monday, followed by a possible issuance of sustainable bonds denominated in dollars. Cameroon and Slovakia are also seeking to issue bonds this month.
Local currency debt is generally seen as the most vulnerable to a rise in the dollar or US yields because any one of them reduces spread returns. A 25 basis point increase in yields in a month would be a turning point for high-yielding currencies such as the Turkish lira, the South African rand and the Mexican peso, according to a study by Bloomberg News.
Emily Weis, a macro strategist at State Street in Boston, recommends buying shares in developing countries. TS Lombard also holds the view that they are safer because they are more driven by the dollar and US equities than by US Treasuries.
During the underwriting panic in 2013, the 120-day correlation between the MSCI emerging market equity index and the Bloomberg Barclays Treasury index was less than 0.2. At the peak of the global bond sell-off this year, the index showed little link to US yields. By contrast, its correlation with the Bloomberg dollar index is about-0.6 and that with the S & P 500 index is about 0.7.
If US yields rise moderately, emerging market high-yield dollar debt could also be popular. Emerging market junk bonds are up 1 per cent this year, surpassing low-yielding investment-grade bonds as interest rates on 10-year Treasuries climb from 0.9 per cent to about 1.6 per cent. Frontier markets provide a higher buffer against rising interest rates, with bonds in the world's least developed economies returning 3.9% so far this year.
This has prompted Fidelity to turn to local bills in Egypt, Ghana and Uganda, as well as foreign currency bonds in Argentina, Ecuador and Zambia, said Paul Greer, a London-based fund manager at Fidelity, which has about $700 billion in assets under management. " William Bolley's Marcelo Assalin expects u.s. yields to climb to 2% by the end of the year, making junk bonds more attractive.
Still, for others, deciding which is the best place to survive the storm represents examining the performance of countries during the pandemic. To that end, Alan Wilson, a portfolio manager at, Eurizon SLJ Capital, says the company is looking for countries with strong demand for commodities and capital commodities.
He expects the market and the Fed to wrestle over when to raise interest rates and are prepared to pursue higher yields by holding foreign currency debt from Egypt, Ghana and Oman.
"continued US exceptionalism is very likely to lead to further testing of the Fed's easing stance," Wilson said.