UPDATE 1-Banks shift EM FX exposure as currencies suffer biggest drop in a year

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LONDON, March 8 (Reuters) - A selloff in emerging market currencies deepened on Monday as investors pulled back from stocks and bonds from across the developing world, fearing the rise in U.S. yields and the dollar had further to run.

MSCI's emerging market currency index lost as much as 0.8% for its biggest daily drop since the pandemic roiled markets in March 2020. The index - which is heavily skewed towards Asian currencies - slipped to a three-month low of just under 1,700 points, Refinitiv data showed.

While China's onshore yuan slipped 0.5% to turn negative on the year, non-Asian EM currencies such as the Turkish lira, South African rand and Mexican peso weakened more than 1% to the dollar.

Several big investment banks said they were reducing emerging market exposure.

Morgan Stanley downgraded its view on emerging market currencies and bonds for the second time in two weeks, predicting EM FX would fall 4%-5%. It encouraged bond investors to switch to safer, investment-grade debt.

The bank had warned two weeks ago of "downside risks" to its neutral view on emerging currencies and fixed income, citing a slim margin for error due to rising U.S. Treasury yields.

"It turns out there was no margin for error at all," said Morgan Stanley strategist James Lord in a note on Monday.

"We take another bearish step in our positioning and expect the weakness in EM currencies and fixed income to continue, though positive global sentiment should keep the weakness orderly."

An emerging equity index is a touch off erasing all its year-to-date gains, losing 2% on Monday while JPMorgan's local currency debt index has returned -5.4% since the start of the year and the hard-currency debt benchmark is down 4.6%, according to Refinitiv data.

Most analysts see emerging economies as better positioned than during the big 2013 selloff that became known as the taper tantrum because many now run balance of payments surpluses.

But many still are fragile following the COVID-19 crisis making them vulnerable to the rise in U.S. Treasury yields. Ten-year Treasury yields, the reference rate for global borrowing costs, are up 70 basis points so far this year.

That prompted JPMorgan to trim its emerging markets exposure to "marketweight" from "overweight" in late February.

As U.S. real yields -- yields adjusted for inflation -- pushed higher last week, Citi said investment outflows continued from emerging markets, basing its analysis on client data.

"Both real money and leveraged investors were net sellers in each region," Citi's Dirk Willer said.

Goldman Sachs predicted pressure from rising U.S. Treasury yields was here to stay and advised holding commodity-exposed currencies such as the rouble.

"On the whole, EM FX has been fairly resilient through this 'reflation tantrum' in core rates," Goldman analyst Zach Pandl said.

"However, even if the current sharp rate rise episode moderates, our forecasts for a surge in growth and sequentially higher inflation in Q2 means that we are likely to see renewed bouts of rate pressure in the spring and summer."

(Reporting by Karin Strohecker and Marc Jones; Editing by Hugh Lawson)