Last week, the Fed raised interest rates by a quarter-percentage point and, a day later, the ECB announced its decision to quit its QE bond buying program at the end of this year, although keeping its main interest rate at 0%. For the first time in over a decade, the world’s two most important central banks are tightening monetary conditions in tandem.
The monetary tightening path in the U.S. puts emerging markets at risk, as we saw during the 2013 taper tantrum. A rising U.S. Dollar and U.S. yields are creating double trouble for emerging markets, because of increasing borrowing costs (as much debt in emerging markets is denominated in U.S. Dollars), higher import inflation, and investors getting a lower return on their overseas investments hence pulling their money away from emerging markets. With more hikes expected in 2018, emerging markets’ troubles with U.S. monetary policy will not easily subside. Furthermore, the ECB’s statements are considered dovish, further boosting the U.S. Dollar. But in the longer term, interest rates will also increase in the Eurozone, causing emerging markets’ position vis-à-vis the Euro to deteriorate.
In recent months, we have already seen how a stronger U.S. Dollar and rising U.S. yields have hit the Argentine Peso and Turkish Lira hard, forcing their central banks to intervene heavily to keep up their currency and dragging many emerging market currencies in their wake. As a result, central banks in emerging markets will face a balancing act between keeping their currencies afloat and maintaining easy monetary conditions to benefit from the current growth cycle of the global economy (as we have written before). However, in contrast to five years ago, many emerging markets’ economies are in a healthier state (e.g. in terms of current account deficits, reforms, government finances, or political risk), so that the current “risk on environment” provides them an opportunity to outperform and capitalize on their improved fundamentals from recent years.
