Spectre of Treasury rout comes at grim time for EMs

New York

EMERGING markets (EMs) haven't looked so exposed to climbing US yields for almost half a decade.

The correlation between currencies in the developing world and short-term Treasuries increased to around the strongest level since 2017 last week. It underscores the potential fallout for the asset class if traders continue to price in a faster-than-expected tightening drive by the Federal Reserve.

Signs of stress are already showing. EM stocks just capped their longest string of weekly declines in more than two years, while bond funds in the space registered US$2.8 billion of outflows in the week through Sept 29, the biggest exodus since March, according to data from Bank of America.

Investors also withdrew money from exchange-traded funds that buy developing-nation stocks and bonds. That comes as the yield on two-year Treasures briefly spiked to levels last seen since the start of the pandemic over a year ago.

Unlike a sell-off in the Treasury market earlier this year - spurred by optimism over a flood of monetary and fiscal stimulus - the impetus this time is the risk of accelerating inflation, and increasingly hawkish central banks.

That's even as the momentum for growth and assets across the developing world begins to fade. In the event that developing-market yields "prove more responsive to inflation over the last three months of the year, this would be bad news for EM FX, which posts its worst returns when US rates rise and EM equities fall", strategists including George Saravelos at Deutsche Bank wrote in a report to clients last week.

It's a stark contrast from just a few months ago, when the likes of Goldman Sachs Group and Lazard Asset Management called the end of two decades of underperformance for emerging-market stocks against their developed peers.

For State Street Corp, a jump of more than 50 basis points in 10-year US yields over three months would be a "sign of caution", while William Blair Investment Management said a 30-basis-point increase over the coming weeks would be enough to trigger outflows.

Any shock to 10-year yields driven by concern over the outlook for consumer prices or policy could be greater than previous blows seen this year, according to a Bloomberg study.

Traders are already bracing for a slew of inflation releases this week from developing economies, including South Korea, Russia and Mexico.

Last month, a Citigroup index of economic surprises in the emerging world fell below zero for the first time in over a year, meaning data releases have been worse than expected.

The bearish backdrop could hardly have come at a worse time for EM investors, which have been bruised by the fallout of China Evergrande Group's debt crisis and Beijing's regulatory crackdown on key sectors including technology.

EM stocks extended losses on Monday, alongside weakness in 10 of 24 developing currencies tracked by Bloomberg.

Among the most exposed local-currency bond markets are those of Turkey, Indonesia and Mexico given their fiscal and current-account deficits, and lower foreign-exchange reserves, according to Emily Weis, a macro strategist at State Street in Boston. BLOOMBERG