COMMENT: The Fed and emerging markets – be careful what you wish for

By bne IntelliNews May 11, 2015

Peter Szopo of Erste Asset Management -


The disappointing first-quarter growth of the US economy – with GDP up a meagre 0.2% (annualized) – has fuelled expectations that the Federal Reserve will delay its long-awaited rate hike. Particularly emerging market (EM) economies and assets are said to be among the main beneficiaries of a delay because, according to a recent comment in the Financial Times, the Fed’s hesitation is “removing some of the gloom from the outlook for emerging markets”. This claim is not without substance – in fact, the ‘taper tantrum’ of 2013 following the first signs of the Fed’s adopting a more restrictive policy bias provided some empirical evidence. However, the reality is a bit more complex for a number of reasons:  

First, while the case for a rate hike has weakened, markets still assume that the Fed’s patience will not last much longer. The probability of a rate increase – implied by Fed funds futures – in the course of the year is now lower than at the start of the year, but the fall has been moderate. Still the probability of a rate lift-off in the first quarter is almost 60%, and of a hike before year-end around 86%.


Second, the comment’s implicit assumption that the outlook for emerging markets is significantly affected by the timing of the Fed’s raising rates by 25 basis points seems simplistic. Yes, the emerging world is not without problems and the growth outlook falls short of what emerging market investors were used to see in the past, but US monetary policy is only one of many factors – and not even the most important one – driving longer-term emerging market growth prospects. Domestic reform and Chinese growth, for example, are certainly more important.

Third, as a group, emerging markets are more resilient in macro-economic terms than in earlier cases when the Fed started a new rate cycle. Policy options have improved due to a more flexible exchange rate policy, leverage (particularly in the public sector) is lower and currency reserves are higher than in 1994, 1999 and 2004 – the last three dates, when the Fed started a fresh rate cycle.

Unsurprisingly, the macroeconomic situation differs across the emerging market universe, with some economies like South Africa, Turkey and Brazil being more fragile than others, which is also reflected in a more diverse equity performance in recent months (see chart below). However, there are no real signs of a looming general emerging market financial crisis.


Fourth, as far as the stock market performance in emerging markets is concerned, the empirical evidence about what may happen in the course of a fresh rate cycle is mixed, as I pointed out in an earlier comment on this site. While in previous instances – in line with expectations – stock markets suffered immediately after the rate lift-off, in 1999 and 2004 they recovered quickly, posting relative and/or absolute gains within six to twelve months after the event.

Fifth, and probably most importantly, while the Fed’s interest rate decision is, in policy terms, a discrete choice, it is a not a fully exogenous move. In fact, the Fed is responding to what the policymaker members see happening in the broader economy in terms of the outlook for growth, the labour market and inflation – as eloquently summarized by Ms Yellen in a recent speech on “Normalizing Monetary Policy”. While a delay of a rate hike beyond, say, September may appear helpful for the emerging market universe – at least for its weaker, ‘unbalanced’ members – it would also be the reflection of a much softer US economy than currently assumed. It is doubtful, whether against the backdrop of slower US and, consequently, global growth persistently low interest rates would provide support for emerging market economies and assets. It is no surprise, therefore, that the performance of emerging market stock markets both in absolute terms and versus their developed markets’ peers turned negative following the release of the feeble US growth data for the first quarter.

Of course, it would be helpful if the Fed remembered Thomas Jefferson’s dictum that “delay is preferable to error” and did not repeat the European Central Bank’s 2011 policy mistake of hiking rates prematurely. Better though, even for emerging economies and stock markets, would be a situation in which the Fed could raise rates on the back of an increasingly robust US labour market, a rebound in economic growth and a (moderate) pick-up of inflation. 

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