The sharp selloff in emerging markets offers a preview of what could happen when Federal Reserve policymakers eventually taper monetary stimulus.
While no major decisions are expected after the Fed wraps up its meeting Wednesday, investors worldwide will see if Chairman Ben Bernanke walks back a May 22 remark that bond purchases could be scaled back "in the next few meetings" if the labor market keeps improving.
That statement is largely blamed for sending MSCI's emerging-market stock index down 10% for this year, while a gauge of developed-market stocks is up about 9%.
JPMorgan's index of emerging-market sovereign bonds is off 6%. U.S. Treasuries have fallen too, causing yields to jump. Private foreign investors sold a record $30.8 billion in long-term Treasury debt in April.
Global QE Addiction
The Fed's $85 billion in monthly quantitative easing is officially tied to the U.S. labor market's health and prices, but central bankers may have to consider the recent turmoil when deciding when to trim QE.
"The Fed can't take emerging markets for granted," said Ed Yardeni, president of Yardeni Research.
The International Monetary Fund seemed to predict the past in an annual report on the U.S. economy Friday, warning that a spike in rates ahead of a stimulus withdrawal "could have adverse global implications, including a reversal of capital flows to emerging markets and higher international financial market volatility.
Investor overreaction to normalization in Fed policy could also slow U.S. growth, the IMF added.
Emerging-market governments are scrambling to stem capital outflows and falling currencies. Indonesia's central bank unexpectedly hiked interest rates Thursday, and Thailand sold dollars to prop up the baht.
Brazil, which recently lifted rates to fight inflation, loosened some capital controls initially imposed to curb the flood of "hot money" from the Fed's QE.
Bubbles that sprang up in emerging markets like the Philippines, Malaysia and Turkey are starting to see capital dry up, Yardeni said.
"If we continue to see stress in their equity and bond markets, something will blow up somewhere," he said.
But he's not sure how much emerging-market governments can do. Their exports of commodities and labor-intensive manufactured goods are already under pressure from yen weakness brought about by Japan's aggressive monetary easing.
The arrival of "Abenomics" earlier this year was followed by rate cuts from Australia to Israel to the eurozone and set off accusations of currency wars.
Now emerging markets are being whipsawed. Lifting interest rates would make exports pricier, and lowering them could worsen capital flight.
One risk channel is corporate debt. Currency depreciation boosts servicing costs for dollar-denominated debt and raises the chance of default.
For now, currency declines are relatively moderate and probably won't factor into the Fed's next meeting, said Jay Bryson, global economist at Wells Fargo.
The countries seeing the worst declines are also not big trading partners with the U.S., limiting the economic effects here.
Dovish Fed statements could trigger a temporary rally in emerging markets, but investors understand the QE endgame is getting closer, he said.
"We'll continue to see adjustments. It doesn't mean it has to be Armageddon," Bryson said.
'Open Mouth' Committee
Meanwhile, more money will likely come into the U.S. and stay, providing a cushion against slower global growth and any financial strain in emerging markets, Yardeni predicted.
Bernanke could calm markets if he clarifies the Fed's message and cuts through the clutter of statements from other policymakers, he added.
"He needs to establish some discipline over what people call the Federal Open Mouth Committee," Yardeni said. "You want signals. You don't want noise."