EMD Relative weekly notes

Week Ending June 8, 2018


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

We think we have begun a period of adjustment in emerging markets that will be required in the current environment to produce a more stable framework for growth to stabilize in the next year or so.

First, Argentina announced it was seeking an IMF deal (finalized this week as bigger than expected) coupled with aggressive rate hikes, then Turkey hiked twice for a total of 425 basis points, and finally Brazil massively expanded a swaps program meant to stabilize its currency while avoiding hiking into a very sluggish economy.

What ties these countries together? A continued divergence in major central bank monetary policy is sweeping the US dollar higher and squeezing liquidity from EM, which results in higher currency volatility and losses, necessitating higher interest rates and leading to a period of lower growth--much like 2014-2016, we expect. The graph below shows how the rates differential between the Fed and ECB has significantly more to go if the Fed stays true to its "dot plot". Without a hint that the direction of travel of this dynamic will slow or end, eventually the difference weighs on other currencies versus the dollar--that turn happened in mid-April of this year just like it did in June of 2014.

Source: Bloomberg. Measuring the Federal Reserve’s Upper Bound rate and the European Central Bank’s deposit rate. Data as of June 7, 2018. Past performance is not guarantee of future results.

A second and different dynamic is the relative shift in central bank balance sheets (shown in the next graph). We are likely entering a direction of travel where the Fed will be shedding its balance sheet while the ECB's remains static for multiple months. That should keep rates differentials across yield curves high, and this would be another tailwind for the dollar.

Source: Federal Reserve Bank and European Central Bank (in USD 1,000,000s). Data as of June 1, 2018. Past performance is not guarantee of future results.

So what is required of EM in this environment is higher real interest rates to more effectively compete for capital to bulwark currencies. For the three countries mentioned above (except Brazil, with the caveat that longer yields have soared much higher in a massive curve steepening), that process has begun. In short as we pointed out earlier when dollar yields were equal to local yields on
average, investors must get paid more -- especially to invest in credits like these. Current account deficits are no longer tolerated.

While those already invested in these countries have been badly wounded, new investors are likely to pounce at signs of stabilization, which we are seeing at least in Turkey. We believe South Africa is likely to require higher rates under this framework, and Mexico also may have to return to its hiking cycle.

So while headlines are trumpeting the existence of an EM crisis, the seeds of recovery have just now begun to be sewn--again like in 2015 and early 2016.

The last piece is for the Fed to signal an end to the massive policy differentials, which appears to be in sight. We emphaisze the word "signal" instead of "complete." The market will be quick to notice the shift and, if it has sufficient confidence it will be priced in extremely rapidly--witness the sea of change in mid-January 2016. In our view, that will likely make emerging markets the place to be--just like later 2016 and 2017.