Positive U.S. Real Yields Add to Toxic Emerging-Market Cocktail

(Bloomberg) -- The long list of worries for emerging-market money managers threatens to expand further with positive real yields in the U.S. worsening an outlook already clouded by slowing growth and the war in Ukraine.

The first warning shots were fired last week, when the inflation-adjusted rate on 10-year Treasuries briefly rose above zero for the first time in two years. While the level didn’t hold for long, it did signal a turning point -- the era of negative yields that sent investors rushing to emerging markets in search of higher returns may be nearing an end as the Federal Reserve hikes rates aggressively.

A sustained and substantial increase in U.S. real yields would be bad news for developing nations as it typically boosts the dollar and sucks capital out of riskier assets -- just like it did in 2008 and 2013. Investors are already bracing for that outcome: Franklin Templeton is cutting positions in high-yield debt, while Fidelity International bets against emerging-market currencies and State Street Corp. shuns local debt of nations with weak finances.

“As U.S. yields go into positive territory, that starts tightening financial conditions and does put pressure on a lot of emerging markets, particularly the weaker ones,” Mohieddine Kronfol, the Dubai-based chief investment officer for Middle Eastern and North African fixed income at Franklin Templeton. “We still think there is much to worry about from growth to geopolitics, and from inflation to monetary policy.”

It’s not just that positive U.S. real yields are coming, but that they’re coming at a bad time for emerging markets. Inflation in the developing world has stubbornly stayed high into the second quarter, belying some money managers’ expectation that it would peak by the end of March.

That means it’ll take even longer before emerging economies themselves can offer investors positive real policy rates, leaving them at a disadvantage versus the U.S. which can. As many as 35 of the 42 nations tracked by Bloomberg have negative rates. Turkey’s minus 47% is the world’s worst real rate. 

“We were expecting that emerging-market inflation would start peaking as early as in the first quarter, but all bets are off post the sharp increase in commodity prices post Ukraine war,” said Guido Chamorro, the co-head of emerging-market hard-currency debt at Pictet Asset Management. 

Growth Conundrum

Investors are also grappling with the war’s impact on food and energy prices, as well as concerns surrounding China’s sagging economy. Emerging market local-currency bonds have slumped about 5% this year, surpassing the record full-year loss of 3.8% in the wake of the 2013 taper tantrum.

“Growth expectations continue to fall and inflation remains at generational highs in many countries providing a very difficult macro cocktail for investors,” said Paul Greer, a money manager at Fidelity International in London. “Higher U.S. real yields is a headwind for all risk assets and of course emerging markets will not be immune to that.”

Local-currency bonds of Turkey, Indonesia and Mexico may be the most vulnerable to a surge in U.S. yields given their persistent fiscal and current account deficits, lower foreign-exchange reserves and high foreign ownership of bonds, said Emily Weis, a macro strategist at State Street in Boston. Whenever U.S. yields jumped more than 50 basis points over a three-month period, the yields on those developing countries’ bonds had risen by more than twice that, she said.

Bullish Case

Meanwhile, some investors argue though that positive U.S. real rates may herald a potential peak in the Fed’s policy hawkishness. For Nordea Investment, that would be the time to turn “tactically bullish” on emerging-market currencies and sovereign debt, said Witold Bahrke, a Copenhagen-based senior macro strategist at the firm. 

“I definitely think U.S. real yields crossing the zero-line is an important milestone on the path towards a peak in the monetary headwinds emerging-market investors are facing in 2022,” said Bahrke. “Positive real rates would also bring us closer to peak Fed hawkishness, which is the ultimate requirement for risk appetite to stage a meaningful comeback.”

But that remains a contrarian view for now. Most money managers believe emerging economies remain exposed to capital-flight risks because there’s little they can do to change the equation vis-a-vis improving yields in the developed world. Much of the inflation faced by them is not their own doing, but driven by external factors. Many central banks have already raised rates to their limit and have little room to tighten further. 

So, despite being ahead of the curve, higher U.S. real rates will put more pressure on policy makers to extend their tightening cycles, said Ed Al-Hussainy, senior currency and rates analyst at Columbia Threadneedle Investments. Monetary policy decisions in Russia, Hungary and Colombia will be closely watched this week. 

“The most vulnerable assets are low-yielding bonds in Asia and Eastern Europe which are exposed to inflation spillovers from the Russia war and the Covid disruptions in China but don’t have a real yield buffer relative to the U.S.,” Al-Hussainy said. “Commodity exporters in Latin America who have been accelerating their tightening cycles have more of a buffer.”

Here are the main things to watch in emerging markets in the week ahead:

• China’s April purchasing managers’ indexes due Saturday will probably show a deeper contraction in activity, underscoring the damage to manufacturing and the service sector from Covid lockdowns
  • The nation’s coronavirus outbreak worsened as rising cases in Beijing sparked jitters about an unprecedented lockdown of the capital, sending the offshore yuan sliding to its weakest level since November 2020
  • China’s industrial profits for March are likely to register a decline, according to Bloomberg Economics
• Russia is likely to cut interest rates on Friday as policy makers shift their focus toward cushioning the impact of international sanctions on the economy
  • Wednesday’s release of activity indicators will reveal how the first full month of war and sanctions have hit the economy
• Hungary will probably raise its benchmark rate by a full percentage point on Tuesday as the war in Ukraine fans inflation
• Colombia’s monetary policy meeting on Friday will also be closely watched, with policy makers split on the appropriate speed of future rate increases
• Turkey’s central bank will publish its inflation report on Thursday. The nation has maintained its ultra-loose monetary policy despite inflation accelerating to a two-decade high in March
• South Korea, Taiwan, the Czech Republic and Mexico will report on gross domestic product

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