LONDON (Reuters) - Rising U.S. bond yields and a resurgent dollar are kicking up a storm which threatens to rip through emerging markets this year.
They reflect a tightening of financial conditions that, on their own, could choke off flows into risky assets and markets. Together, they have the potential to trigger far more damaging waves of selling.
The Institute of International Finance said last week that the rise in the 10-year U.S. bond yield to 3 percent and the rampant dollar have prompted a sharp downturn in portfolio flows to emerging markets, triggering a “reversal alert”.
The reversal may already be underway. According to the IIF, emerging market equity and bond fund outflows in the last two weeks of April totaled $5.6 billion.
(For a graphic showing Emerging market portfolio flows - IIF, click here: reut.rs/2I9vB0n)
Data from fund flow trackers EPFR Global show that the cumulative inflow into emerging market bond funds since 2005 peaked at $194.5 billion in January. It’s currently some $6 billion lower than that now, and the $4 billion outflow in March was the biggest monthly outflow since late 2016.
EPFR’s fund flow figures show appetite for emerging market stocks remains firm. But the MSCI’s global emerging market equity index is still down 10 percent from its peak in late January, lagging Wall Street and the broader MSCI World index.
The spike in the dollar and Treasury yields casts an increasingly large shadow over global markets. The 10-year yield hit 3 pct late last month for the first time in four years, and the dollar is now at its strongest level since January.
At 3 pct, a 10-year U.S. Treasury bond - probably the safest and most liquid security on the planet - seems a whole lot more attractive to a U.S. money manager than an emerging market bond carrying increasing credit and exchange rate risk.
“Rising global rates put the spotlight on high debt levels across emerging markets, which are likely to be more of a consideration for EM portfolio investors going forward,” the IIF warned.
Emerging markets were last at the mercy of rising Treasury yields and dollar in 2013-2016, a period book-ended by the Fed’s “taper tantrum” of May 2013 and the culmination of a near three-year, 30 pct dollar rally in December 2016.
Investors pulled tens of billions out of emerging markets.
(For a graphic showing Emerging market fund flows - EPFR, click here: reut.rs/2JH7MKA)
They have yet to bail like they did in mid-2013 when then Fed chief Ben Bernanke signaled an end to super cheap and easy money. The $18 billion outflow from EM bond funds in June that year remains the largest on record, EPFR Global data show.
And there’s nothing to suggest a repeat is on the cards this time around. But emerging market exposure to a stronger dollar and higher U.S. borrowing costs has been built up to such an extent in recent years that nerves will be jangling.
More than $900 billion of emerging market bonds come due this year, according to the IIF. Countries like Turkey, Poland and Argentina that rely on large inflows of foreign capital to plug their current account gaps are particularly vulnerable to rising U.S. borrowing costs.
Many other countries are exposed to a higher dollar and U.S. yields. The dollar’s 10 pct decline last year, its biggest annual fall since 2003, fueled a huge increase in dollar-denominated credit around the world.
According to the Bank for International Settlements, dollar-denominated credit to non-bank borrowers outside the United States increased by 8 pct last year to $11.4 trillion, of which emerging markets account for some $3.7 trillion.
The borrowing binge across emerging markets, in particular, was remarkable. The annual growth rate of dollar credit to non-bank borrowers in emerging countries more than tripled to 10 pct, led by an “unprecedented” 22 pct surge in debt issuance in the second half of 2017, the BIS said this week.
(For a graphic showing Emerging market dollar credit - BIS, click here: reut.rs/2reaekF)
The dollar’s weakness was expected to deepen this year, and hedge funds and speculators built up their largest short dollar position since 2011, Commodity Futures Trading Commission figures show.
But propelled by rising U.S. interest rates and bond yields, the dollar has rebounded in recent weeks and is now its strongest in four months. It rose 2 pct in April alone, its best month since late 2016, and is showing no sign of slowing down.
That massive short dollar position is at risk. A scramble to cut it will add even more rocket fuel to the currency’s rally, piling further pressure on dollar borrowers in emerging markets.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever, editing by Larry King