Specifically, it is important to evaluate the possible implication of US fiscal stimulus recently passed by Washington. Traditionally, the US fiscal stimulus happens amid business cycle downturns when Fed is cutting interest rates and this combination is a big boon to emerging markets as it improves their exports and lowers interest rates. However, this time the situation is much more complicated as US fiscal stimulus is occurring at a time when the US economy is close to full employment, inflation is close to target and Fed is raising rates. This is an historical anomaly. One way to think about the situation is to ask who will absorb the rising supply of US treasuries amid US fiscal stimulus?US treasuries supply to rise… who will buy?
Generally speaking, US Fed, EM central banks and global private sector (insurance, pension funds etc globally) are three large buyers of US treasuries. Among these, it is clear that the Fed will actually add to the supply of Treasuries as it normalises its balance sheet. Indeed, the combined supply of US Treasuries (US government + Fed) could ramp up from under $700 billion in 2017 to over $1.5 trillion by 2019. If so, can the EM central banks do the needful? Unlikely, because the EM surpluses today are not even a shadow of what they used to be during 2005-2008 when EM surpluses kept US bond yields under check despite sustained monetary tightening by the US Fed (remember Greenspan’s famous “bond market conundrum”?).
In other words, the combined official sector (Fed and EM central banks) is not positioned to absorb the expanding supply of US treasuries. If so, the global private sector will have to ramp up the purchases of US bonds. And history shows that this happens when private participants perceive higher risk in their portfolios e.g. during crisis-like situation (e.g. around China’s RMB devaluation episode, amid European debt crisis and so on). In such scenarios, US yields surely fall but it is a fall driven by global rush towards safety of US Treasuries and therefore no comfort for EM assets. Even if US yields fall, EM rates could still remain elevated/move higher amid this rush to safety. Recall the situation that played out in 2015 when China was persistently losing reserves amid capital flight (selling US treasuries) and yet US bond yields fell by nearly 100bps but that fall in US yields was no comfort for EMs as the fall in US yields was a reflection of global private sector rushing toward safety of US treasuries amid mounting China risk.
EM dynamic more akin to 1990s than 2000s
No surprises therefore that we have seen involuntary rise in interest rates in EM, much ahead of their growth cycle. In recent months, bond yields in EMs have risen 70-80bps, a few central banks — Turkey, Indonesia — have been forced to hike rates amid pressure on exchange rates (EM FX down 8-10% from their peak). Now, one may ask, how come Fed’s tightening cycle of 2004-2007 was so peaceful for EMs (indeed EM saw full-fledged upswing in business cycle and asset prices)? It was so because the Fed and EM monetary cycles (and business cycles) were fully aligned. Growth and rates fell together and rose together.
Indeed, the history which is more instructive for our current situation is Fed’s tightening cycle in 1990s (not 2000s), which proved quite troublesome for EMs (the Mexico crisis in 1994, the Asian Financial Crisis in 1997) precisely because EMs were not in a position to match US rates higher. Put differently, the global economy is basically facing two misalignments. One is the mismatch between US fiscal and monetary policies — the former is adding stimulus, the latter is withdrawing (this will tend to push rates higher); and second, US monetary cycle and EM monetary cycle (which would tend to push dollar higher). Left to itself, this dynamic will pose serious challenge to macroeconomic management in EMs.
What is the way out?
The Fed backing off from aggressive rate hikes will be one such development. This in turn could be led by unexpected fall in US inflation (or sharp fall in oil prices) and/or softer than expected incoming economic data from the US. Also if EM situation deteriorates, Fed could certainly reassess the situation as has happened so often in history.