ORLANDO, Fla. – If the Federal Reserve is using 1994 as a template for its likely aggressive monetary tightening ahead, then emerging market investors can be forgiven for feeling nervous given what followed around the globe back then.
Refinancing needs in developing economies are at record highs. Inflation is high and rising despite many emerging central banks pre-empting Fed rate rises over the past year, and so too are government debts as a share of gross domestic product.
To be sure, emerging markets’ external position is much stronger today than it was in the mid-1990s – debts are mostly denominated in local currency, far fewer exchange rates are pegged rigidly to the dollar, and many central banks are sitting on huge piles of foreign cash reserves.
But the sharp rise in US bond yields and a surging dollar are putting the squeeze on emerging economies’ growth and overall debt sustainability. Emerging market assets have been under pressure for some time.
The surge in US real, or inflation-adjusted, yields is particularly noteworthy. As real returns on US bonds turn positive again, western investors fearful of currency risk, capital loss and inflation feel more comfortable locating in the relative safety of Treasuries, and capital gets sucked out of high octane emerging markets.
The 10-year US real yield has leapt towards zero from around -1.10 percent in the past six weeks. Patrick Curran, senior economist at Tellimer, says markets may still be underpricing how much upside it still might have.
“Gone are the days where you could just pencil in 2 percent inflation forecasts and price out your real rates from there,” Curran says, noting that headline US inflation is the highest in 40 years, 10-year inflation expectations are the highest in 25 years, and emerging market inflation rates are spiking too.
US money markets now expect the Fed to raise interest rates by 50 basis points at each of its next three meetings for a total of 275 basis points this year, culminating in a ‘terminal’ rate next summer that could exceed 3.5 percent.
That would be similar to 1994-95, where the Fed’s 300-bps tightening cycle in a 12-month period included multiple 50-bps moves and even a 75-bps increase.
That bond-crushing, quick-fire tightening under the guidance of then Fed Chair Alan Greenspan successfully managed that rare twin feat of snuffing out inflation while avoiding recession.
