(James Saft is a Reuters columnist. The opinions expressed are his own)
By James Saft
May 21 U.S. interest rates are staying low for quite some time, a backdrop which should, all else equal, favor emerging markets.
Remember the taper tantrum last year, when fragile emerging market countries took huge hits as investors moved to tighten liquidity ahead of an anticipated Fed cutback on bond buying? Well that's all in the past and, particularly in the past week, the noises from within and around the Federal Reserve are painting a newly dovish picture.
That's significant for all markets but it is an unadulterated bonus for emerging markets, particularly those which need to attract capital and are therefore highly sensitive to its global cost and availability.
The taper has become reality, and yet, amid signs of economic weakness from Europe and the U.S., market interest rates have dropped and the bid for riskier assets has generally been relatively good.
This is not to ignore the host of issues in emerging markets from Russian aggression in Ukraine to a rather precipitous slowdown in China. But remember, any problem which arises from within emerging markets will only be made much worse by a hawkish Fed. Indeed a Fed which is tightening has historically been an important contributory cause of problems from within emerging markets. Supportive policy from the Fed is almost a necessary precondition for outperformance in emerging markets.
WHAT'S UP WITH THE FED?
So first off, why should we believe that the Fed is now more dovish than a week or two ago?
For one thing, Ben Bernanke, now doing the rubber chicken circuit at something like $250,000 a pop, is telling us so. While reports are all at best second hand at these private, no-journalists-allowed dinners, the vibe coming out through the media is that rates are not headed up soon.
Not only did Bernanke indicate the Fed might tolerate inflation above its 2 percent target, one guest came away with the impression Bernanke believes the fed funds rate won't return to its historical average of about 4 percent in his lifetime. (here)
But if you don't like back-room tea-leaf reading, and who could blame you, take it straight from the Fed in speeches and interviews. Bill Dudley, president of the New York Fed, argued publicly this week against the idea that the 2 percent target was a ceiling, maintaining that, once reached, we might be expected to spend as much time above that level as below it.
Dudley was noncommittal about the timing of a first rate rise and stressed that increases, once they begin, would be quite slow. (here)
Or consider an interview Boston Fed President Eric Rosengren gave to the Wall Street Journal in which he proposed that the Fed may want to continue reinvesting maturing securities held on its balance sheet even after the taper is completed, maintaining that a large balance sheet may be a needed tool to allow the Fed to manage financial stability. (here)
Low rates for a long time and a Fed with both a huge balance sheet and a tolerance for small inflation overshoots must sound pretty good to Indian central bank chief Raghuram Rajan or South Africa's Minister of Finance Pravin Gordhan.
VOLATILITY AND FLOWS
Indeed we've seen some signs that emerging market assets are moving to price this in, and there is some hope that this continues. The MSCI emerging markets index has outperformed both the S&P 500 and Euro Stoxx 50 year to date and over the past week and month.
Particularly interesting is a decline in volatility in emerging markets. The CBOE's Emerging Markets ETF, a fear gauge for emerging markets, has shown a strong decline in volatility recently, slumping 35 percent since mid-March, far outpacing the fall in the U.S. VIX volatility index.
Analysts at Barclays Capital note that the relative volatility in emerging markets compared to developed ones has dropped sharply since last year but that the extra real yield you get by holding an emerging market sovereign bond has actually increased, something they believe may indicate scope for a reduction in emerging market risk premiums.
"The key question is: is this elevated level of risk premia reasonable? Our analysis looks at potential equity risk premium drivers and suggests the answer is no," Barcap global equity strategist Joao Toniato writes in a note to clients.
Much depends on what use emerging market officials make of an extended period of easy liquidity. It would be easy, as in the past, to use it as an excuse to delay reforms and make politically popular but perhaps low-yielding investments.
Still better, both for emerging markets and for investors in emerging markets, to hold the choice in your own hands rather than have your tightening done for you in Washington. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)