Specter of Treasury Rout Comes at Grim Time for Emerging Markets

On Oct 3, 2021

(Bloomberg) — Emerging markets haven’t looked so exposed to climbing U.S. yields for almost half a decade.

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The correlation between currencies in the developing world and short-term Treasuries increased to around strongest level since 2017 last week. It underscores the potential fallout for the asset class if traders continue to price in a faster-than-expected tightening drive by the Federal Reserve.

Sings of stress are already showing. Emerging-market stocks just capped their longest string of weekly declines in more than two years, while bond funds in the space registered $2.8 billion of outflows in the week through Sept. 29, the biggest exodus since March, according to data from Bank of America.

That comes as the yield on two-year Treasures briefly spiked to levels last seen since the start of the pandemic over a year ago.

Unlike a selloff in the Treasury market earlier this year — spurred by optimism over a flood of monetary and fiscal stimulus — the impetus this time is the risk of accelerating inflation, and increasingly hawkish central banks. That’s even as the momentum for growth and assets across the developing world begins to fade.

Should developing-market yields “prove more responsive to inflation over the last three months of the year, this would be bad news for EM FX, which posts its worst returns when U.S. rates rise and EM equities fall,” strategists including George Saravelos at Deutsche Bank AG wrote in a report to clients last week.

It’s a stark contrast from just a few months ago, when the likes of Goldman Sachs Group Inc. and Lazard Asset Management called the end of two decades of underperformance for emerging-market stocks against their developed peers.

For State Street Corp., a jump of more than 50 basis points in 10-year U.S. yields over three months would be a “sign of caution,” while William Blair Investment Management LLC, said a 30-basis-point increase over the coming weeks would be enough to trigger outflows.

Traders are already bracing for a slew of inflation releases this week from developing economies, including South Korea, Russia and Mexico. Last month, a Citigroup Inc. index of economic surprises in the emerging world fell below zero for the first time in over a year, meaning data releases have been worse than expected.

The bearish backdrop could hardly have come at a worse time for emerging-market investors, which have been bruised by the fallout of China Evergrande Group’s debt crisis and, Beijing’s regulatory crackdown on key sectors including technology.

The yield premium on sovereign bonds from the developing word over U.S. securities is already testing the highest level since March, while MSCI Inc.’s equity benchmark for the asset class just posted its biggest quarterly decline since the onset of the pandemic.

Among the most exposed local-currency bond markets are those of Turkey, Indonesia and Mexico given their fiscal and current-account deficits,…