This website uses cookies to collect usage information in order to offer a better browsing experience. By browsing this site or by clicking on the "ACCEPT COOKIES" button you accept our Cookie Policy.

Three Reasons EM Is Less Vulnerable to Another Taper Tantrum

Schroders

Contributor:
Schroders
Visit: Schroders

By:

Senior Emerging Markets Economist

David Rees explains why EM investors shouldn’t fret too much over a Taper Tantrum 2.

Financial markets in the emerging world suffered a wobble earlier this month. It followed the belated “blue wave” in the US election which appeared to clear the way for a large fiscal stimulus, and sparked a sell-off in the Treasury market.

The bout of volatility harked back to the Taper Tantrum that rocked EM markets in 2013. Fears of a repeat, as the US economy recovers this year, have become a major concern among investors.

We remain relatively dovish on the outlook for Federal Reserve (Fed) policy; we expect no increases in interest rates for the next three years, with the tapering of asset purchases as part of quantitative easing set to only begin in spring next year. But it is at least worth considering the spill-over to EM if the brightening outlook for the US economy causes the Fed to withdraw its extreme policy support sooner than previously assumed; beginning with a tapering of its asset purchases this year.

A sudden jolt in the Treasury market would be likely to spark a period of global risk aversion and EM assets would undoubtedly come under pressure.

Higher risk-free rates as a result of a further sell-off in Treasuries would dampen some enthusiasm for risky assets such as those in EM. However, improved macroeconomic fundamentals suggest that EM would bounce back more quickly than in 2013.

Why did emerging financial markets “wobble” in early January?

Democratic Party candidates secured victory in two run-off elections in the US state of Georgia to give the incoming Biden administration wafer-thin control of the Senate.

The belated “blue wave” appears to have cleared the way for a substantial fiscal stimulus. That saw the yield of 10-year Treasuries climb by 20bp to almost 1.14% in the space of a week – the highest in a year – as the prospect of a faster economic recovery, along with higher inflation and debt, led to speculation that the Fed would have to unwind its large policy support sooner than expected.

The sell-off in Treasuries coincided with a wobble in EM financial markets. It stirred painful memories of the Taper Tantrum in 2013 when then-Fed chairman, Ben Bernanke, caught investors off-guard by telling Congress that asset purchases included in Quantitative Easing could be reduced.

That sparked a sell-off in the Treasury market, which saw nominal 10-year yields climb by about 100bps in the space of three months as real yields surged.

Fears that the era of easy money that underpinned a hunt for yield and drove strong inflows to EM during the preceding three to four years was about to end saw investors take flight and triggered a sell-off across financial markets. Equities tumbled, credit spreads widened and pressure in foreign exchange markets forced central banks in several EMs to raise interest rates in order to protect their capital accounts.

falling real treasury yields drove a sustained tightening of non-IG spreads after GFC

The effects were particularly severe in those EM, such as Brazil, India, Indonesia, South Africa and Turkey (the “fragile five”), that had built-up large current account deficits that were funded by short-term capital inflows. This left them vulnerable to a “sudden stop” in capital flows.

2013 taper tantrum

We noted in our Q4 outlook update that another Taper Tantrum was an obvious risk scenario that would have a negative impact on EM economies and markets. This remains a risk scenario that we continue to track. However, there are at least three reasons why we do not expect a repeat of the severe market volatility and lasting economic damage experienced in 2013:

1) The Fed is not about to take away the punch bowl

First, the Fed is likely to tread more carefully than it did in 2013. There are of course question marks about how long the Fed can really keep a lid on extremely low bond yields as the economy recovers. And there is always a risk that mis-communication by Federal Open Market Committee members will unsettle investors at some point in the future. However, the Fed’s new Average Inflation Targeting (AIT) framework implies that policymakers will want to see the whites of the eyes of inflation before withdrawing policy stimulus and it seems likely that financial repression will continue as fiscal needs dominate the agenda in the US.

There will be bumps along the way, but this suggests that real bond yields in the US will remain negative for some time to underpin demand for risky assets such as those in EM.

2) Flows to EM have been subdued in recent years

Second, there is not a large positioning overhang in EM like in 2013.

Investing in EM has become a consensus trade in recent months, but the bigger picture is that capital inflows have been subdued in recent years. Certainly they have not been on the same scale as they were in the four years or so after the Global Financial Crisis.

The huge capital outflows during the Covid crisis prove that this does not preclude severe flight to safety in the event of a major external shock. However, it does suggest there is less risk of a Taper Tantrum leading to a prolonged period of capital outflows. In simple terms, the less capital that flows into EM, the less there is to come out.

despite strong recent inflows there is not a positioning overhang in EM like 2013

3) The Covid crisis has cleaned up EM balance of payments positions

Third, and related to this, subdued capital flows to EM in recent years mean that economies have not had the means to fund large current account deficits and built up the kind of large external imbalances that were exposed in 2013.

Indeed, the Covid crisis has actually cleaned up balance of payments positions in most EM as deep recessions have caused imports to collapse and current accounts to move into surplus.

Structural current account deficits will re-emerge as economies recover, but as things stand most EM economies are relatively well placed to withstand capital flight. This suggests that currencies are not particularly overvalued at the moment and also reduces the need for central banks to unexpectedly hike interest rates in order to bolster the capital account.

That’s not to say that EM would be immune to a taper tantrum if it were to happen and some economies such as Turkey and Colombia still have external vulnerabilities. But these improved fundamentals suggest that the macroeconomic and market consequences ought to be less severe than they were in 2013.

the covid crisis has cleaned up EM current account deficits

As we noted last year, if AIT leads to a prolonged period of capital flows to EM then it is likely that this would lay the foundations for some kind of future shock as economic imbalances build. But this is a risk for 2022 and beyond.

Originally Posted on January 28, 2021 – Three Reasons EM Is Less Vulnerable to Another Taper Tantrum

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.

Disclosure: Schroders

Important Information: This communication is marketing material. The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realized. These views and opinions may change.  Schroder Investment Management North America Inc. is a SEC registered adviser and indirect wholly owned subsidiary of Schroders plc providing asset management products and services to clients in the US and Canada.  Interactive Brokers and Schroders are not affiliated entities.  Further information about Schroders can be found at www.schroders.com/us. Schroder Investment Management North America Inc. 7 Bryant Park, New York, NY, 10018-3706, (212) 641-3800.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from Schroders and is being posted with permission from Schroders. The views expressed in this material are solely those of the author and/or Schroders and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.

Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

Disclosure: Forex

There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.

trading top