Frontier countries to suffer most if Fed rate hits 6%: analysts

EMERGING markets are facing their demons as traders mull whether US Federal Reserve interest rates will rise as high as 6 per cent – a level that could kick weaker countries when they are down while diverging global growth paths, and China’s reopening might cushion some of the blow for the bigger ones.

Expectations for where the Fed’s terminal rate will peak have been rising at breakneck speed: Markets are pricing in a 5.5 per cent to 5.75 per cent range for September, while the CME FedWatch tool shows an almost 50 per cent chance for the band to hit 6 per cent that month.

The scale and pace of the move make for uncomfortable reading for investors in developing stocks, bonds and currencies, which have often buckled under rising global rates.

“The current repricing risk in the Fed’s terminal funds rate to perhaps 6 per cent in a short period of time is in the context of (the) response to inflation running stubbornly well above target in a weakening global gross domestic product (GDP) growth environment,” Satyam Panday, chief emerging-markets economist at S&P Global Ratings, told Reuters.

“This mix is generally a net negative for emerging markets.”

Expectations for further Fed hikes had been for 25-basis-point increments, but Fed Chair Jerome Powell on Tuesday (Mar 7) brought a faster pace back to the table. Few expect a smooth ride for the remainder of the week, with the monthly US jobs report for February providing markets with more evidence to chew over.

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“Fed-tightening towards 6 per cent would firmly test historical ‘pain thresholds’ for emerging-market assets,” said UBS strategist Manik Narain in a note. He predicted that India’s rupee, China’s yuan and the Philippine and Chilean pesos could weaken as much as 5 per cent if the Fed ramped up rates to 6 per cent.

A recent Barclays analysis showed that a 50-basis-point Fed rate hike would increase interest-rate volatility; it “would be more destabilising initially, as it typically comes with emerging-market foreign exchange underperformance, which could trigger a further leg up in emerging-market rates”.

Analysts at JPMorgan expect the US dollar to weaken once the terminal rate stabilises, but a 50-basis-point Fed hike “would be a regime-shift in favour of outsized USD-strength”.

“Frontier-markets is where you’ll likely see the brunt of the hit” of sharply rising rates, said Sahil Mahtani, multi-asset strategist at investment firm Ninety One.

The number of smaller, riskier emerging markets where investors demand a premium of 10 percentage points or more over safe-haven US Treasuries has remained broadly steady at around 30 countries, with a recent rally bringing no relief, analysts at Tellimer found. These countries, which include Kenya, Egypt and Pakistan, are essentially locked out of capital markets.

But local fixed-income markets in bigger developing economies are also set to feel the pinch. A 6 per cent Fed rate environment alongside still-hot inflation does make short-term rates most vulnerable in Chile, India, Poland, the Czech Republic and Hungary, UBS found.

Flows to emerging markets soared in January, but slowed to a crawl in February, signalling a warning to investors. Citi data showed on Monday that outflows resumed last week, with real money leaving Latin America and emerging Europe, the Middle East and Africa, while hot money, or speculative capital, left Asia and Latin America.

Investors, especially on the equities side, could see China’s reopening somewhat offsetting a looming downturn in the US and some of Fed rates’ historic weight on emerging markets.

Emerging stocks are up just 2 per cent this year after a combined 26 per cent drop in the previous two, and they broadly lag developed peers. Chinese equities could provide a safe haven in a 6 per cent fed funds rate scenario, UBS said.

The emerging-market universe being more Asia-centric than in previous sharp increases of global rates means that investors cannot “look at the textbook of history”, said Nuno Fernandes, a New York-based portfolio manager for GW&K’s Emerging Wealth Equity Strategy.

China accounts for nearly a third of the emerging-market equity benchmark, and almost 5 per cent in the fixed-income hard-currency index, which is supportive of the asset class.

“Investors are conditioned to think that emerging-market tail risk emerges in the context of aggressive US rate hiking cycles,” said Ninety One’s Mahtani. “I think it’s dangerous to say this time is different, but it feels like it’s not that mechanical this time.” REUTERS