How has emerging market turmoil impacted the US debt market? (Part 1 of 7)
Emerging market turmoil
Which came first? Did the turmoil in emerging markets impact U.S. bond markets, or did U.S. monetary policy for open market purchases of government and agency-backed securities impact emerging markets?
Ominous signs with respect to economic fundamentals were brewing for emerging markets since the start of 2013. Governments across the board (with the exception of China) struggled with record deficits both at the fiscal level and the balance of trade level. Investors in a number of emerging market countries (including India, Brazil, Russia, Turkey, and Argentina) were getting jittery, and most stock markets and currencies had already experienced corrections between May and August 2013.
Adding to this background, in December 2013, the U.S. Federal Reserve announced that it was reducing its asset purchases by $10 billion per month, split between $5 billion from agency-backed MBS and $5 billion from longer-term Treasuries. This was followed by a similar announcement on January 29, 2014, reducing open market purchases by the same amount.
With the onset of the Fed’s tapering program, bond prices were expected to decline and yields were expected to rise. However, contrary to market expectations, bond prices rose throughout January and into February. The Vanguard Total Bond Index (BND) rose to $81.38 during this time—its highest level since May 21, 2013 (prior to the FOMC release hinting at the onset of tapering), and reversing trends seen in 2013.
The Fed’s tapering announcements also caused a mass exodus of funds from emerging markets as investors pulled more than $12 billion from emerging market stocks in January. The iShares MSCI Emerging Markets Index (EEM) is down 8.9% since the Fed’s first tapering announcement on December 18, 2013. In reaction to the taper, central banks across the board (most notably in countries such as Argentina and Turkey) scrambled to raise interest rates in a bid to prevent dollar outflows and shore-up their currencies.
Most emerging market countries were running high fiscal and current account deficits, which were being increasingly financed through short-term foreign inflows. Others, like Argentina, had severely depleted foreign exchange reserves, which made it difficult for them to defend their currency. These factors contributed to their vulnerability as investors made a flight-to-safety following the Fed taper. This in turn buoyed up the U.S. bond markets, which were expected to decline following the Fed taper.
To learn more about how the biggest emerging market, China, impacted the rally in U.S. bonds, continue to Part 2 of this series.
Browse this series on Market Realist: