So this is probably a good time to reassess your carry trades.
As noted, a seemingly innocuous event (weak French 30Y auction) sparked a dramatic selloff in bunds earlier this morning, as German 10Y yields suddenly spiked to their highest levels since January of 2016:
That had immediate knock-on effects across Eurozone bonds and it quickly spilled over into equities as the DAX and Eurostoxx dipped.
Between that and the rising tide of geopolitical event risk, one has to wonder if it’s time to abandon EM – at least until we get more clarity on North Korea and Syria and until DM tantrum risk has subsided.
Below, find a particularly timely piece from Bloomberg’s Andrew Janes, out just hours before this morning’s bund bloodbath…
History shows emerging market investors should deeply fear the potential for coordinated global monetary policy tightening.
- As speculation builds the world’s major central banks may be close to following the Federal Reserve down a more hawkish path, a look back to the last such period, in 2006, sheds light on what this may mean for emerging markets
- Despite the prevailing wisdom of the last few years that higher U.S. interest rates are bad for developing nations, a long-term analysis shows the MSCI EM Index has been resilient during previous Fed tightening cycles
- But that changes when the Fed’s major peers are all raising rates at the same time or when there’s speculation they will do so. The chances a sudden selloff become much greater
- That’s what happened in 2006, when the MSCI EM Index plunged more than 24 percent from May 10 through June 13. A gauge of EM currencies tumbled almost 5 percent in the period. During the rout, India’s Sensex plummeted as much as 10 percent on May 22, reportedly prompting the police to be on the lookout for suicidal investors
- At the time, the Fed was coming to the end of a tightening cycle that lasted from June 2004 to June 2006. The ECB was in the early stages of a run of rate hikes that went from November 2005 to July 2008, the PBOC was tightening, while the BOE was taking a pause before a resumption of rate increases in August 2006. Even the BOJ had just hiked after a prolonged period of quantitative easing and zero interest-rate policy
- While most emerging markets are on a firmer macroeconomic footing than they were during the taper tantrum in 2013, it’s notable that the crash in 2006 wasn’t driven by internal EM fundamentals
- In a paper published that year, the IMF cited rising inflationary pressures and expectations of a synchronized tightening of global monetary policies as the reasons. It highlighted the increased cost of funding leveraged trades, the perceived downside risk to growth and currency volatility
- So there are similarities with the current rally, which is being mainly driven by improving EM fundamentals abetted by abundant liquidity
- To be sure, the major central banks are not where they were in 2006 just yet. But the BOE and Bank of Canada are now seen as more likely than not to join the Fed in raising rates before the year is out, based on overnight index swap rates. And even the probability of an ECB hike, once seen as all but impossible, is slowly growing