Analysis | Fed Is Not Falling Into an Emerging Markets Trap. Not Even Close

Industry titans have reasons to be annoyed. Data due Wednesday will likely point to consumer inflation marching to a fresh four-decade high, thereby tying the Fed’s hands to another 75-basis point rate hike in July. In just four months, the spread between the 10-year Treasury bond and the two-year note, traditionally a reliable barometer of recession risks, inverted three times. The International Monetary Fund cut its growth projections for the US economy this year and next. 

Meanwhile, some of the time-tested portfolio risk management methods, such as hedging US equity exposure with long-dated Treasuries, are broken. Not only did the S&P 500 and Treasuries both deliver negative returns this year, but the correlation between the two asset classes has turned strongly positive. 

No doubt, US markets have been weird lately, but everything is relative. Judging by global fund flows, it’s hard to argue investors have lost faith in the Fed.

Rather, developing economies have taken the brunt of the blow. Investors pulled over $50 billion from emerging markets bond funds this year, the most severe in at least 17 years. The redemption on US bond funds, by comparison, has remained fairly tame; sovereign debt even saw inflows, despite losing 7.5% year-to-date. 

This is because the Fed is blessed with a currency that is going in the right direction. A strong dollar, which is necessary to tame domestic inflation, keeps portfolio money from fleeing US assets.

Emerging markets, on the other hand, don’t have such luxury. Central bankers there are trapped in a singular focus on inflation, responding more aggressively than expected, and still falling short of keeping up with the dollar. Their currency weakness, in turn, feeds into domestic price increases in everyday products from wheat to natural gas. 

Case in point, Hungary surprised with a massive 185 basis point rate hike to 7.75% in late June, the biggest rate move since 2008. But the boost to the forint against the dollar and euro evaporated quickly. This year, Hungary’s currency has fallen about 20% against the dollar, despite raising its policy rates by 5.35 percentage points.

Granted, the Fed is also focused on inflation right now. But at least it’s not in a game of cat and mouse with any other major central bank. It can try to strike a balance between inflation and economic growth.

US market players are able to contemplate when the Fed might start cutting rates again — the second quarter of 2023 if futures markets are to be believed. This thought exercise is not even on the table for most developing countries right now. Markets have not completely lost faith in the Fed.

More From This Writer and Others at Bloomberg Opinion:

• Fed Being Pushed Into Developing-Economy Camp: Mohamed El-Erian

• Jobs Report Gives Powell a Little More Runway: Jonathan Levin

• There’s Good News for the Economy, If You Look: John Authers

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. She is a CFA charterholder.

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