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EM and the Fed: Smaller pullbacks and greater recoveries

The Emerging View

01 June 2016

Investors in Emerging Markets (EM) should no longer fear Fed events – instead they should actively add into any temporary market nervousness ahead of hikes, especially in local markets. As the Fed prepares to hike for a second time, it is noteworthy that EM pullbacks are becoming shallower, while recoveries after Fed events are getting stronger. We expect Fed tightening will now result in net positive returns for EM investors that buy ahead of events. The very gentle trajectory for Fed hikes is unlikely to hurt EM countries fundamentally, yet EM bond yields already hover close to levels last seen when the Fed had policy rates above 5%. This provides important protection. There has also been a notable flip in correlations between performance in the short end of the US Treasury curve – reflecting market expectations of Fed action – and EM rates and FX markets. Specifically, EM local rates markets now react less and recover faster than US markets, while EM FX now has more gain than pain around Fed events, also thanks to shifting correlations. We demonstrate these important positive changes in correlations, which are also evident in EM’s Dollar-denominated credit markets. Finally, we show that the real vulnerability lies in developed fixed income markets, where bonds are showing increasing sensitivity to Fed tightening.

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