Listen, emerging markets may be in trouble, ok?
You know that because you haven’t been living in a cave with no Wi-Fi for the past month.
The problem here is that there’s a self-feeding dynamic at play with the dollar, fiscal stimulus and the Fed and that dynamic appears to have been supercharged (or at least reinforced) by the move higher in crude and a concurrent deceleration in Eurozone/U.K. growth.
We’ve been over this repeatedly (see here and here), but the gist of it is that the market seems to believe that the Fed is concerned about the possible inflationary effects of late-cycle fiscal stimulus piled atop an economy operating at or near full employment.
That’s stoking rate hike bets which in turn underpin real yields. That’s dollar positive and lately, the greenback’s correlation with 10Y yields (and rate differentials) has been restored, after disappearing earlier this year:
Well, breakevens have been following crude higher and a soft patch for the Eurozone economy in Q1 helped push rate diffs in favor of the greenback.
When you add all of that up, what you get is a scenario where the dollar is driven continually higher, squeezing the spec short on the way up.
There are a couple of possible circuit breakers here, with the most notable being a scenario where real yields rise enough to push equities materially lower and the read-through for financial conditions is material enough to cause the market to start to price out some of the additional hikes.
As Bloomberg’s Luke Kawa noted a week ago, there’s an argument to be made that 2018 has been a real yields story. Every time we get up near 80bps (and beyond) on reals, stocks start to struggle:
A related possibility in terms of circuit breakers is that the stronger dollar eventually caps crude’s rally, which in turn puts the brakes on inflation expectations and thereby similarly prompts the market to price a less aggressive Fed.
In any event, as long as the current dynamic persists, the read-through for EM is inherently precarious as the market begins to believe that Turkey and Argentina were simply the weakest links, as opposed to idiosyncratic stories with no connection to the rest of the developing world. Now that the external shock from rising U.S. rates and the stronger dollar has tipped the wobbliest dominoes, the broader EM complex will start to come into focus. That’s what you saw this week as the pain is now manifesting itself in Indonesia and Brazil, where efforts to halt the currency pain with relatively “hawkish” central bank decisions fell flat.
Well in his latest note, Deutsche Bank’s Aleksandar Kocic takes a quick look at the reaction function of EM in the context of the Fed’s decision calculus and the dynamics that define Jerome Powell’s efforts to normalize the mode of the curve in the course of reducing the odds that the tail risk inherent in the bond trade gets realized.
As Kocic notes, underscoring everything said above, “USD is emerging as the key variable [as] it presents a compact summary of the underlying macro risks that could destabilize the current Fed path.”
Underlying Kocic’s discussion is the notion that the current system is, as we put it weeks ago, self-regulating. “Market positioning and flows are likely to cause offsetting pressure to each macro risk and therefore help stability of the system.”
Assuming that the tail risk inherent in some kind of acute bear steepening episode isn’t realized (when you think about that, don’t forget the possibility that the Fed ends up having to cut rates in a downturn, thus pulling the rug out from under the dollar at a time when America’s fiscal position is in shambles and thereby creating the conditions wherein there’s no sponsorship for the U.S. long end), then the near-term risk is (more) bear flattening. Here’s Kocic describing the causality chain:
We start at the lower left corner. Fed hikes and strong USD open up the EM dilemma: Facing the outflows or defending the currency at expense of stifling the growth. This implies both more volatility and potential sell off in EM, and bearish pressure on the long end of the UST that would offset the underlying bid for US bonds (strong USD is bullish). Turbulence in EM could have a knock-on effect on risk assets in the US. An example is the 2015 episode where asset managers faced redemptions due to EM losses and had to sell the best performing assets (US equities) to cover those costs. This means more turbulence in developed markets and possible tightening of financial conditions, which could question the strength of the USD and possibly push Fed to take a pause.
Virtually all of the dynamics outlined here at the outset are touched on in that excerpt. There’s a self-regulating character to the whole thing assuming, as Kocic puts it, everything “remains localized and [doesn’t] trigger tail risk.”
If you look down there in the bottom right-hand corner of the schematic, you run into the circuit breaker scenario where enough of an uptick in equities vol. causes a Fed pause. Of course if the market takes some of the additional hikes out, Eurodollar short gets squeezed:
Then comes volatility in the front end. Here’s Kocic again:
The EPFR data reflecting the ETF and Mutual Funds Flows show continued outflows from the emerging markets and inflows into the short end of the UST curve, which is only increasing the stress in this sector. So, although we should see continued stability at the long end of the curve due to offsetting pressures between macro and flows, a slow grind of the front end, if persists, could morph into a volatile whipsaw. Further strength in the USD and the front end sell off on the back of more hawkish Fed could be potentially bearish for risk assets and act as a trigger for rates reversal.
This is just another avenue whereby the circuit breaker is flipped that ends up (hopefully) putting a floor under U.S. equities.
Of course implicit in the above is that when that happens, you’re likely to see a rather dramatic bout of bull steepening.
