Markets are focused on one big thing right now: when will the Fed raise rates.
In a speech at Bloomberg’s Americas Monetary Summit on Monday, New York Fed president Bill Dudley indicated that it will likely be appropriate for the Fed to raise rates sometime this year, as he has in recent speeches.
But in his speech on Monday, Dudley also addressed another, knock-on effect that markets are worried an interest rate hike could have: a major sell off in emerging markets.
Dudley allays these fears by citing ways that emerging market economies have changed since the major debt crisis that was sparked by the Federal Reserve’s tightening cycle in the late 1990s.
“First, many [emerging market economies] appear to be better equipped today to handle the Fed’s prospective exit from its exceptional policy accommodation than they were during past tightening cycles. This reflects the fundamental reforms that EMEs have put in place over the past 15 years, as well as the hard lessons learned from past periods of market stress. Among the positives are:
- The absence of pegged exchange rate regimes that often came undone violently during periods of acute stress;
- Improved debt service ratios and generally moderate external debt levels;
- Larger foreign exchange reserve cushions;
- Clearer and more coherent monetary policy frameworks, supporting what are now generally low to moderate inflation rates;
- Generally improved fiscal discipline; and
- Better capitalised banking systems, supported by strengthened regulatory and supervisory frameworks.”
Whether markets are convinced that this time, it’s different, remains to be seen.
The basic outline of why the Fed raising rates could be such an issue for emerging markets is that the US will simply be a more attractive investment opportunity. If an emerging market issues US dollar-denominated debt that yields, say, 6% over 10 years, that is a pretty good deal relative to US 10-year debt which yields about 2% a year, particularly if an investor doesn’t think the issuing emerging market will default.
For example, if the Fed raises rates, US 10-year yields could rise, to maybe 3% or 4%. And given that investors widely view nothing as a safer bet than US Treasuries, someone could sell the EM debt, buy US Treasuries — now with higher yields — and take a risk somewhere else in their portfolio.
Another (sort of) related problem is that as the US dollar rallies, emerging markets that have issued debt in US dollars now have to pay more to pay that money back. If the Thai government, for example, issued dollar-denominated debt when the That baht was at 20 to one US dollar, and now one dollar is worth 25 bahts, the government has to come up with 25% more bahts to pay back the debt.
And so again, the big question is when does the Fed raise rates. What happens after, however, is probably the deeper, more unexpected, and more interesting story.
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