COLUMN-Dark cloud of tighter US financial conditions hangs over EM: McGeever – News Couple

COLUMN-Dark cloud of tighter US financial conditions hangs over EM: McGeever

(The opinions expressed here are those of the author, who is a Reuters columnist.)

Written by Jimmy McGyver

ORLANDO, FL, Dec 8 (Reuters) – If the consensus view of a strong dollar and higher US bond yields in 2022 proves accurate, emerging markets are on a tough path, particularly in the first half of next year.

How much the bump will be will depend in large part on the extent to which the Fed ends bond buying and begins its eventual rate-raising cycle to tighten US financial conditions through higher dollar and Treasury yields.

Emerging markets are particularly vulnerable on three fronts to a tightening of US financial conditions: diminished capital and portfolio inflows. High inflationary pressures. As a result of these two reasons, domestic interest rates rose, which slowed growth.

The Bolman Sachs US Financial Conditions Index shows that America’s borrowing, lending, investing and spending floor has scarcely been more fertile since the index was compiled more than 30 years ago.

The easing of conditions this year has been almost entirely due to the boom on Wall Street. This offset the tightening caused by higher 10-year Treasury yields and a stronger dollar, on track for their biggest annual gains since 2013 and 2015, respectively.

While it is reasonable to assume that asset markets are already priced to some extent in the expected gradual Fed cut and rate hike next year, it is also reasonable to assume that financial conditions will remain tight from current historical lows.

Take the 10-year Treasury yield, which is currently around 1.50%. That may be about 50 basis points higher than the previous year, but it’s 50 basis points – or more – less than many analysts thought it would be 12 months ago.

The flat US yield curve indicates that the 10-year yield may not rise much from here. Likewise, there may not be much room for the dollar to rise further, having already strengthened by 7% this year.

But emerging markets are very sensitive to both at the moment, where small rallies could have a big impact.

“A challenging year for emerging market assets is coming to an end, but next year could bring even bigger hurdles,” SocGen economists wrote in a recent note, adding that emerging market inflows would be reduced by the Fed’s less accommodative monetary policy. The dollar, high US yields.


This is already happening, although cycles of anti-inflation policy tightening are underway in many emerging countries, particularly Brazil and Russia. Bond flows, in particular, are drying up.

Data from the International Institute of Finance in Washington shows that net debt portfolio flows to emerging countries last month amounted to just $6.3 billion, the lowest level since the $6.5 billion exit in March.

Economists at the Institute of International Finance say high-frequency data shows that capital flows to emerging markets do not include China halted this quarter, essentially a “sudden stop”.

When US financial conditions are benign and dollar borrowing is cheap, investors seek the higher returns offered by the riskiest assets in the emerging world. But when US borrowing costs rise, this proposition is no longer attractive.

Investors are reluctant to inject liquidity into emerging markets when financial conditions are the most resilient in decades. Will you suddenly tempt them when US and global growth slows, the Federal Reserve raises interest rates, and the dollar is rising?

A strong dollar adds other layers of complexity to emerging markets: the resulting weakening of the local currency is feeding domestic inflationary pressures; It often leads to lower prices for goods exported by many emerging market countries, hitting their terms of trade.

“Stagflation” – or at least “stagflation” – is spreading throughout the emerging world. Citi economists expect emerging market growth to slow to 4.5% next year from 6.6% this year, and inflation to rise to 4.3% from 3.8%.

The dynamic of low growth / high inflation is particularly evident in Latin America, where growth is seen as only 2% and inflation above 10%.

Analysts at Citi and SocGen believe most emerging currencies will weaken against the dollar next year, even as the number of major emerging market central banks raising interest rates is likely from the 12 that have already done so since May.

Citi analysts wrote this week: “Risk appetite towards emerging markets – already looking weak – will be constrained by tightening monetary conditions in the US.”

(Reporting by Jimmy McGyver; Editing by Andrea Ricci)

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