If you’re still long emerging markets or inexplicably still hanging around in some of the various carry trades that are under siege, next week could be a bit of a nail-biter.
While idiosyncratic flareups grab all the headlines, the underlying issue for emerging markets is obviously Fed tightening and while everyone knew the tide would go out sooner or later, what nobody could have foreseen was a scenario where low tide would coincide with the U.S. running a series of policies that have effectively pigeonholed the Fed.
Late-cycle fiscal stimulus is inflationary (lean = hawkish), tariffs are near-term inflationary (lean = hawkish) and the President of the United States has now openly called for lower rates (paradoxically = hawkish, because leaning dovish risks subjecting yourself to allegations of being beholden to the executive).
This week, we’ll get the Fed minutes and Jerome Powell at Jackson Hole. That’s dangerous at a time when EM equities are in a bear market and EM FX is under immense pressure.
(Implied vol. in EM FX relative to DM FX now sitting near decade highs / Bloomberg)
When you think about Powell in the context of EM, never forget these comments delivered at an IMF/SNB event in early May:
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.
It wasn’t going to be “manageable” for EM in the first place, but it’s going to be even less “manageable” in the event we get any more black swan landings like we just got with Turkey. Powell’s speech has the potential the further destabilize EM if he sticks to the script ahead of an expected September hike.
Powell’s comments will come less than 48 hours after the release of the Fed minutes. While the minutes could still be a non-event, they’re going to be scrutinized more in light of recent events in EM. As Bloomberg’s Sid Verma notes, EM USD sovereign debt is now trading wide to U.S. junk, highlighting how palpable the angst truly is around developing economy assets.
“The minutes should also show discussions around the factors that are weighing on participants’ minds for the path of policy such as the slope of the yield curve, the Fed’s estimate of the neutral rate, the economic and financial impact of tariffs on the economy and the Committee’s view on how much overshooting in inflation it is willing to tolerate”, BofAML wrote, in a note dated Friday, adding that “where they end up on these factors will have meaningful implications on the terminal rate.”
Not to put too fine a point on it, but “this is not a drill”, so to speak. EM is hurtling towards a crisis and Powell needs to be very cautious about the messaging this week in Jackson Hole, especially if he knows the minutes are likely to tip more hawkishness.
“In an EM environment of increasing investor caution and rising US interest rates, we think that countries that rely on global savings to fund current account deficits, have large fiscal funding needs or are large net debtors to the rest of the world are likely to underperform”, Barclays said on Friday, stating the obvious, before adding the following color which we’ll present without further comment.
This pattern has appeared in the recent EM sell-off, as currency weakness has been notable in the ARS, ZAR, BRL, INR and IDR; in credit, Argentina and Ecuador followed Turkey’s widening move (Figure 4). With this in mind, the strength of US data in the next few weeks and the FOMC minutes on 22 August should be carefully observed, as a relatively hawkish tone from the Fed could put further pressure on EM currencies, especially of those countries that depend on capital inflows to fund persistent current account deficits.