Hawkish Fed Throws Down Challenge for Emerging-Market Bond Rally

fidwdu31rss185oi0h4tp2kj_media_dl_1.png Bloomberg

Article content

(Bloomberg) — Just when it looked like emerging-market bonds would catch a break from falling energy prices, along came Federal Reserve Chairman Kevin Warsh to spoil the party.

Article content

Warsh’s hawkish pivot at the Fed’s meeting this month cut short a rally in developing-nation debt, limiting the drop in yields fueled by Iran peace talks to much smaller moves than after the April 8 ceasefire. 

Article content

Article content

Article content

Now, the key risk for the securities has shifted to the US central bank, instead of the oil market, say top Wall Street banks including Citigroup Inc. and Goldman Sachs Group Inc. That’s reinforced by a rising correlation between Treasury yields and emerging-market ones.

Article content

Article content

“The path for US interest rates has been repriced much higher,” said Philip Fielding, a portfolio manager at Fidelity International in London. “This has led to broad-based US dollar strength, creating an obvious headwind for dollar-funded emerging-market local currency positions.”

Article content

A hawkish Fed leading to a broad tightening in financing conditions would affect countries relying more heavily on foreign capital inflows, such as Turkey and Colombia, Fielding said.

Article content

Warsh’s comments at his first policy meeting as Fed chair that the central bank won’t tolerate high inflation sent Treasury yields and the dollar higher. The greenback is now on track for its best monthly performance in a year, while the US five-year yield remains more than 60 basis points above where it stood before the Iran conflict began.

Article content

Article content

“Close on the heels of the signing of a US-Iran agreement to end the war, EM local rates are now fighting a new adversary – a hawkish Fed,” writes Goldman Sachs strategists including Kamakshya Trivedi and Danny Suwanapruti in a note on June 18.

Article content

The US-Iran peace agreement this month removed one of the biggest headwinds for developing economies by pushing crude prices lower, easing inflation pressures and giving emerging-market central banks more flexibility over monetary policy. That’s generally positive for developing-nation bonds, as slower inflation raises the prospect of future rate cuts, boosting the prices of existing debt while improving the outlook for many oil-importing economies.

Article content

But the stronger dollar is making emerging-market central banks more cautious about signaling policy easing, limiting the scope for local-currency bonds to extend their gains.

Article content

“The baton of risk factors will only get passed from oil to Fed and El Nino,” Citigroup strategists including Luis Costa wrote in a note published June 18. “Central banks are likely to remain cautious in signaling all clear which could keep risk premia elevated in EM local currency.”