A new IMF paper provides evidence that increased foreign participation in local-currency emerging debt markets has made these significantly more vulnerable to foreign interest rate and risk shocks. Concentration of the investor base and poor economic fundamentals appear to amplify such vulnerability.
The BIS annual report emphasizes the dollar’s pervasive influence on international financial conditions. Post-crisis non-conventional Fed easing has spurred a global credit expansion, including economies that did not need it. Conversely, Fed tightening would reverse easy financing on a global scale, including countries that are ill prepared for it. FX depreciation is unlikely to insulate small and emerging economies from credit tightening.
A new BIS paper provides important lessons for EMFX carry trades, using Latin America as a case study. First, FX carry opportunities depend on market structure and regulation. Second, observed carry typically contains a classic interest rate differential and an arbitrage premium that reflects the state of on-shore and off-shore markets. Third, liquidity shortages and FX proxy hedging constitute major setback risks.
A BIS paper shows significant positive correlation of implied FX volatility and local EM bond yields. Empirically the causality runs mostly from FX to bonds, probably because currency risk is a key factor of foreign bond holdings. However, there can also be reverse causality, when FX derivatives are used as proxy hedge in a bond market turmoil. Since FX volatility is stationary, extreme values can indicate value in local EM bonds.
Dedicated EM exposure has surged by over 55% since 2007, with assets concentrated on few managers. A new BIS article points out that trading flows are correlated due to the widespread use of benchmarks. Moreover, EM asset prices and final investor flows have been pro-cyclical and mutually reinforcing. These patterns seem conducive to recurrent market dislocations.
A new academic paper asserts strong empirical evidence for capital flow deflection: one country’s capital inflow restrictions re-direct capital flows to other countries with similar economic characteristics. While the paper investigates from a policymaker angle, it would be relevant for international macro trading strategies.
Large foreign exchange interventions are common in emerging markets, typically in response to capital flows. What is less well understood is the expansionary (contractionary) impact of FX purchases (sales) on local credit, even if the transactions are sterilized. Sterilization securities mostly end up on banks’ balance sheets, where they function as substitutes for bank reserves, serve as collateral, and encourage banks to expand their loans-to-securities ratios.
The rapid growth in local-currency bond markets in emerging countries has transferred foreign exchange risk from local borrowers to global institutional investors and mutual funds. Gross capital inflows have soared, magnifying the dependence of flows on mutual fund holdings, particularly on volatile open-ended fixed income funds. In the wake of these changes the “beta” of local emerging market assets has risen and the tendency towards herding has increased.
A new BIS paper argues that the expansion of EM local-currency bond markets and foreign-currency EM corporate issuance have strengthened the link between local EM financial conditions and global bond yields. The consequences would be (i) increased dependence of emerging financial systems on developed countries’ non-conventional monetary policies, (ii) decreased effectiveness of local monetary policies, and (iii) new systemic risks.
A recent BIS paper illustrates the consequences of highly accommodative monetary policy in the G3 for East Asia. These include lower policy rates than warranted by domestic conditions, lower bond yields and appreciation pressure on currencies. Importantly, easy G3 monetary conditions stimulate Asian foreign currency borrowing in many forms, including letters of credit, forward selling of foreign currencies and international bond issuance.
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
