March 15, 2017 11:39 am JST
Nicholas Spiro

Asia's emerging markets holding firm against hawkish Fed

New resilience could be strained by Yellen comments, rising Treasury yields

Is a more hawkish U.S. Federal Reserve no longer perceived by international investors to be a threat to valuations in emerging markets?

The odds of a rate hike at the U.S. central bank meeting that ends Wednesday began to rise sharply from late February, with the probability now seen as 95%. This has added to speculation about a faster pace of monetary tightening this year. But judging by the recent solid performance of Asia's emerging markets, the Fed's grip on developing economies is markedly weaker than before.

Since Feb. 27, when the yield on benchmark 10-year U.S. Treasury bonds began to shoot up due to hawkish remarks from Fed policymakers, the main stock market indexes of India, Malaysia and Indonesia have risen 2.1%, 1.7% and 0.9% respectively.

The Malaysian ringgit, meanwhile, has barely moved against the dollar while the Indian rupee has gained 1.2% even while the dollar index, a gauge of the performance of the greenback against a basket of other currencies, has risen 0.6%. In the region's local debt markets, the 10-year bond yields of Indonesia and India have stayed flat..

In stark contrast to the "taper tantrum" in mid-2013 when the unexpected decision by the Fed to begin scaling back its asset purchase program placed the entire emerging market asset class under strain, foreign investors are piling into developing economies.

According to JPMorgan Chase, emerging market bond and equity funds have attracted inflows of $13.6 billion since the beginning of this year, nearly recouping the $13 billion of outflows seen in the seven weeks after the upset victory of Donald Trump in the U.S. presidential election.

A stronger Asia

Asia's emerging markets bore the brunt of the taper tantrum and saw $11 billion in bond and equity outflows due to the sharp rise in Treasury yields following Trump's victory. So why are they suddenly showing so much resilience now?

First, sentiment is buoyed by reflationary forces in the global economy which have become much more pronounced since Trump's victory. According to a note by Barclays Research, economic data surprises in both advanced and developing nations are on balance more positive than negative for the first time since early 2011.

While expectations of pro-growth policies under the new Trump administration have fueled a rally in stocks, bond yields remain relatively low. The yield on 10-year Treasuries currently stands at 2.6%, barely positive in real terms and below its level three years ago when fears about deflation were widespread. Indeed, according to Tradeweb, a bond trading platform, the global stock of negative-yielding government and corporate debt still amounts to a staggering $10.5 trillion.

Second, and more importantly as far as emerging Asia is concerned, worries about a more hawkish Fed have been offset by significant improvement in sentiment toward China, the other main determinant of market conditions in developing economies.

A burst of fiscal and monetary stimulus since mid-2015 has helped stabilize China's economy and provided the catalyst for a sentiment-boosting recovery in commodity markets. A closely watched purchasing managers' index published on March 1 showed that China's manufacturing sector, which was still contracting as recently as February 2016, continued to expand last month, with output more or less on a par with December's 29-month high.

China's own financial markets have also been enjoying a period of calm over the past year. The Shanghai Composite Index has risen 2.9% since the U.S. election, bringing its gains over the past year to more than 13%. The yuan, which lost 4.5% against the dollar in the last quarter of 2016, has been fairly stable since the start of the year as Beijing has taken measures to stem capital outflows.

Vigilance

Still, there are no grounds for complacency - indeed, quite the opposite.

There is mounting speculation that an inflection point has been reached in the conduct of U.S. monetary policy, underpinned by the strength of economic data and the prospect of a sharper rise in inflation, provided Trump wins Congressional approval for his much-anticipated fiscal stimulus package.

The 10-year Treasury yield has shot up nearly 30 basis points since Feb. 24 amid fears that the Fed may be falling behind the curve. A sharper repricing of U.S. monetary policy would drive yields higher, putting further upward pressure on the dollar and placing emerging Asia's currencies and local bonds under renewed strain, particularly the domestic debt markets of Malaysia and Indonesia in which the share of foreign ownership is among the highest in emerging markets.

As oil prices come under pressure again, with Brent crude, the international benchmark, down nearly 10% since March 7, the scope for a significant deterioration in sentiment stemming from a faster pace of monetary tightening should not be underestimated.

If Fed Chair Janet Yellen strikes a distinctly hawkish note at her press conference on Wednesday, the Fed's grip on emerging markets could become a lot tighter once again.

Nicholas Spiro is a partner at Lauressa Advisory, a specialist macroeconomic and property consultancy in London.

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