The rise in global interest rates creates a new shock
The FED and the United Kingdom simultaneously increased their interest rates by a whopping 0.75% yesterday and this sent shock waves across the globe. It is one of the biggest interest rate shocks in recent memory.
The Institute of International Finance refers to it as a global interest rate hike and high inflation shock that has caused longer-term government bond yields in advanced economies to rise sharply.
It has also weighed on flows to emerging markets similar in scale to the Chinese currency’s devaluation scare in 2015 and 2016!
This rise in long-term yields across the G10 is bad news for EM, because longer-term yields are typically the benchmark interest rate for EM.
“We are in a global interest rate and high inflation shock. Longer-dated government bond yields have risen sharply across advanced economies, tightening financial conditions, weighing on growth, and pushing up risk aversion.
“This is also weighing on flows to emerging markets, with our high-frequency flow tracking across the world’s biggest EMs registering outflows similar in scale to the RMB devaluation scare in 2015 and 2016.
“All that said, we are not that bearish on EM. Most of the big emerging markets started hiking well ahead of advanced economies, which now leaves real longer-term interest rates across many EMs well above their G10 counterparts,” says the IIF.
It adds while that provides some protection from this global interest rate shock, there are obviously pockets of weakness in EM – where real interest rates are deeply negative – and risks for these countries are rapidly mounting.
“We see these instances as idiosyncratic, however, and not emblematic of a broader emerging markets problem.”
According to experts from the IIF, the world is experiencing one of the biggest interest rate shocks in recent memory.
That’s not quite so obvious looking at longer-dated nominal interest rates (Exhibit 1), but is very clear looking at real yields, which have risen substantially (Exhibit 2).
The real 10-year Treasury yield in the US is up from -1.1 percent at the end of last year to +0.7 percent now, a bigger rise than during the 2013 “taper tantrum.” Higher debt countries are getting hit even harder.
Italy’s real 10-year yield has risen from -0.7 percent at the end of 2021 to 1.8 percent now, a very sharp – if orderly – repricing.
Global shock and the EM
This rise in long-term yields across the G10 is bad news for EM, because longer-term yields are typically the benchmark interest rate for EM.
High yields in advanced economies mean there is less need to send money to EM. Interest rate shocks therefore historically have generated outflows from EM and this is indeed what we are seeing.
“Our high frequency tracking of non-resident portfolio flows across some of the biggest emerging markets is seeing outflows that are comparable in scale to the 2015/6 RMB devaluation scare (Exhibit 3), with outflows concentrated on non-China EM (Exhibit 4).”
Meanwhile, flows to China have resumed so far this quarter, though they are weaker than in the past, something that dates back to the start of the war in Ukraine.
Inflationary pressures
Global hiking cycles and inflation shocks are traditionally tricky for EM, but they are not that negative. This is because most of the major emerging markets started hiking well ahead of advanced economies, which has pushed up real rates well above G10 levels (Exhibit 5).
Indeed, the normalization in longer-term real rates is something that is mostly a story for advanced economies, while longer-term real yields – in much of EM – normalized in 2021 (Exhibit 6).
“Of course, there are exceptions. Emerging markets where inflation is running well ahead of monetary policy have real rates that are deeply negative.
“Those EMs now face increasing challenges and will likely experience further – perhaps substantial – depreciation. However, we see such countries as idiosyncratic and not emblematic of a broader vulnerability across EM.”