The US 10-year treasury yield recently hit 3%, the so-called “psychological ceiling,” for the first time in five years. It remains to be seen whether the long-term rate will settle there, but capital markets in advanced and emerging economies seem taken aback.
They fear that higher yields combined with the steadily rising short-term benchmark interest rate in the US could signal tighter credit markets.
Viewed from macroeconomic point of view, rising long-term bond yields can be spurred either by expectations of higher inflation or by strengthening economic growth fundamentals, or by both. In this sense, a rising long-term interest rate may not be a worrying signal of economic underperformance in the US.
The US economy is enjoying sustained and robust economic growth. Looming inflationary pressure could be the long-awaited effect of the Federal Reserve (Fed)’s aggressive monetary policy stance, with the US economy finally fending off the global deflationary spiral. While this inflationary pressure partly stems from recent oil price hikes and higher commodities prices partly due to trade tensions and geopolitical risks, a rebound of producer price and consumer price indexes globally should be welcomed as a sign of sustained global economic recovery.
Steady short-term interest rate hikes led to a flatter yield curve that exacerbated fears of a recession in the US, as the economic recession has generally been accompanied by an inversion of the yield curve. A recent rise in the long end of the yield curve should renew optimism that a recession is unlikely and the economy will continue expanding.
Nevertheless, recent capital market jitters particularly in emerging markets, highlighted by Argentina’s bailout request to the International Monetary Fund (IMF) as its currency plunged, warrant a cautionary assessment of the potential impact of the changing global capital market environment and credit conditions.
So far, a series of benchmark rate hikes by the Fed since late 2015 have not triggered a reversal of capital inflows from emerging markets. Instead, the higher rate spurred capital inflows into emerging markets, including those in Asia. Why did this happen? Mainly because a flattening yield curve has convinced global investors to diversify their portfolios into emerging markets. They are on the hunt for yield in markets with relatively lax credit conditions and higher long-term yield prospects.
The inflows might also reflect investor confidence in the economic fundamentals of emerging economies. But the flip side is that it could sow the seeds of downside risks if capital inflows reverse.
The recent strength of the US dollar adds to this concern. A steeper long end of the yield curve, which otherwise might not be a cause for concern, could pose growing downside risks to emerging economies if combined with stronger US dollar. As shown in this chart, from the beginning of 2017 the currencies of both Argentina and Turkey not only have significantly underperformed other peers, but have dropped in value compared with emerging Asian economies.
Both currencies depreciated by around 24% in effective exchange rate terms between January 2, 2017 and May 7, 2018. This is far deeper than the approximately 10% depreciation experienced by Asian emerging economies such as Indonesia and the Philippines.
Argentina is reported to have recently sought a credit line from the IMF, prompting worries about risks spreading to other emerging markets. Given the generally strong economic fundamentals of emerging markets and robust foreign exchange reserves to act as buffers, fears of a contagion may be overblown.
Nevertheless, tightening credit markets may lead to heightened uncertainty about the direction of international capital flows as portfolios and investment profiles are reformulated across emerging markets. Hence, recent high interest rates coupled with a strengthening US dollar compels emerging economies to be more vigilant about the risks posed by potential capital flow reversal.
Weakening local currencies could boost the competitiveness of emerging economies in export markets. But more often than not, emerging economies with a dual deficit problem on both current account and fiscal balance fronts have come under growing pressure from capital flow reversals due to tightening global credit conditions.
Chronic current account deficits pose particularly significant threats to macroeconomic soundness, as they might be filled by foreign direct investment and portfolio investments – with the latter especially exposed to swings in market sentiment. Argentina and Turkey have experienced current account deficits since 2010 and 2002, respectively, and in 2017 these amounted to 4.8% and 5.5% of their respective GDPs. These ratios are much larger than what Asian emerging economies such as India, Indonesia and the Philippines have experienced.
Again, a steepening yield curve in advanced economies may not be bad for emerging economies as it could herald sustained global economic recovery and expanding demand. But there is no guarantee of this desirable outcome. In this sense, the potential risks of capital flow reversals are something that emerging market economies should monitor carefully, given the upward trend of both long-term interest rates and the dollar.
Warren Buffet famously quipped: “You only find out who’s swimming naked once the tide goes out.” Now is the time for emerging economies to take careful stock of their economic fundamentals and intensify efforts to improve their current account and fiscal soundness.