The worst days for emerging markets may be over for this year, but the risks in the EM universe remain. Market participants and analysts are trying to assess the impact of divergence in interest rate policies of the U.S. Federal Reserve and the European Central Bank, as investors try to gauge the pace of global quantitative easing (QE).
The Fed delivered a hawkish message while the ECB committed to freezing rates for longer than expected. Exchange rates are determined by more than monetary policy, as the euro rose against the dollar despite a shift in rates in favor of the U.S. The euro was driven up by a resurgence in activity in the euro-zone last year, which has since faded. After next summer, though, analysts argue that monetary policy will weigh on the dollar. For a start, Capital Economics analysts expect the FOMC to stop hiking its policy rate as the U.S. economy slows. Admittedly, investors aren’t banking on much of an increase in the rate in the second half of 2019. But whereas they seem to be anticipating that it will be kept on hold in 2020, we forecast that 75bp will then cut it. We also suspect that the ECB will tighten policy a bit more quickly than investors are envisaging between mid-2019 and end-2020.
While these issues drove the markets, emerging market debt funds shed $1.3 billion this week, according to EPFR. Turkey was the underperformer, with yields on its $2 billion 6.125 percent 2028 bond ending the week 30bps wider at 7.29 percent-bid, according to IHS Markit. This was not helped by the lira’s renewed depreciation against the U.S. dollar, despite the Central Bank’s aggressive monetary tightening over the past few weeks. As Turkey is headed for elections on June 24, and the uncertainty around how President Recep Tayyip Erdogan’s hand will be after then, is unnerving investors. Analysts don’t expect much buying in Turkey until the elections are over. “There needs to be more clarity about how strong a majority if any, the AKP gets in parliament, and what this means for Erdogan’s ability to deliver the stability and macroeconomic orthodoxy his government has promised,” an asset manager from an international bank argued.