A stronger dollar and rising U.S. Treasury yields have put the hurt on Turkey and Argentina. Economists wonder if the pain could soon spread across emerging markets.
The U.S. dollar, measured via the ICE U.S. Dollar Index DXY, +0.39% a gauge of the greenback against a basket of six major rivals, has jumped 4.2% since the end of the first quarter, having hit a string of 2018 highs in May. It’s up 2% in 2018, after dropping almost 10% in the previous year. This resurgence in the greenback paired with the Federal Reserve’s gradual path to monetary policy normalization makes dollar funding more expensive for emerging market borrowers.
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Although both Argentina and Turkey struggle with additional idiosyncratic issues, their reliance on dollar-denominated debt is a big part for why their currencies sold off. The Argentine peso USDARS, +0.7361% hit a record low against the buck earlier this month, while Turkey’s lira USDTRY, +4.1807% fell to a fresh historical low against the U.S. unit on Wednesday amid a continued slide across the board in emerging market currencies.
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“We turned more cautious on emerging markets in February and signaled substantial overvaluation for the Argentinian peso and Turkish lira,” wrote analysts at the Institute of International Finance, led by chief economist Robin Brooks. “Both currencies have fallen sharply since then, but spillovers to the rest of the EM complex have been limited so far.”
Yet, there are others, most notably South Africa, Colombia, Egypt, Mexico and Indonesia, which could also suffer, they said. They focused on nonresident portfolio flows into those countries, which have risen to levels last seen in 2013 and signal the potential for turbulence if the flows reverse.
Indonesia’s rupiah USDIDR, +0.45% for example is already trading around a 31-month low against the U.S. dollar, having steadily fallen in the year-to-date. Similarly, Egypt’s pound USDEGP, -0.0112% is hovering around its lowest level last summer.
“The underlying driver of the sell-of is this year’s rise of the 10-year Treasury yield from 2.4% to 3%, which is half the size of the move that started the taper tantrum,” the economists said. The 10-year U.S. bond yield TMUBMUSD10Y, -1.81% hit a seven-year high of 3.126% on Friday. Yields and bond prices move in opposite direction.
The taper tantrum was characterized by a jump in U.S. government bond yields in 2013 after the Federal Reserve signaled it planned to taper the amount of assets purchased under its quantitative easing program.
Emerging market equities have felt some pain, with the iShares MSCI Emerging Markets ETF EEM, -0.77% off 2% in May, leaving it down 2.4% year to date versus a 1.5% rise so far in 2018 for the S&P 500 SPX, -0.27% On the debt front, the VanEck Vectors Emerging Markets Local Currency Debt ETF EMLC, -0.70% is down 5.3% in May and 6.6% year to date, while the iShares JPMorgan U.S. Dollar Emerging Markets Bond ETF EMB, +0.22% is down 1.6% in May and also off 6.6% year to date.
“If emerging markets are this vulnerable to what can only be described as a moderate rise in global funding costs, we worry about the underlying resilience in EM,” the economists wrote.
“Our interpretation is that it becomes harder to identify profitable opportunities as the global ‘flow’ cycle matures so that nonresident portfolio flows shift to increasingly idiosyncratic places,” the IIF analysts wrote, adding that this was how the large positions in Argentina and Turkey, relative to other emerging markets built up.
But while Treasury yields breached the psychologically important 3% mark for the first time in four years in May, they had been hovering close to it for weeks and the rise in yields is more accurately characterized as moderate. “This leaves us worried how well the EM complex will digest a continued move higher in global funding costs,” the economists said.
Put on a seat belt. It could get rocky.