Emerging markets fearing US dollar yields China trifecta

In a quiet post-NFP Monday, markets focused on the research from the Bank of International Settlements finding that emerging markets face rising risk of servicing their USD-denominated debt owing to the rising value of the US currency. But the real danger will come from bounce in US bond yields as well as persistent deterioration in Chinese economic figures.

The BIS story caught the attention of FX and bond traders particularly as the USD index soared to fresh five-year highs following Friday’s release of the November jobs report showing the biggest monthly increase in nonfarm payrolls in nearly three years.

Not only 75% of emerging markets’ $2.6 trn raised in foreign bonds were denominated in US dollars, but also $3.1 trln in international banks cross-border loans to emerging markets were largely in USD as of mid- 2014.

EM’s risk from further appreciation in the US currency could be further exacerbated if borrowers’ rising currency costs are combined by an increase in US bond yields. As can be seen in the chart below, emerging markets’ fears from higher US yields have been alleviated by a 30-basis point decline in US ten-year yields.

Don’t forget bond yields

Between a rising USD and ascending bond yields, the latter poses the more direct risk to EM borrowing costs. The chart below shows how emerging market performance (measured by the total performance of Morgan Stanley’s EM equity funds) fared worst during rising bond yields, such as in December 2013, when bond yields reached the 3.0% level, which was the highest in two years.

And China

Looking ahead, the worst combination of dangers for EM would be double whammy of rising USD & US bond yields, alongside a third ingredient of deteriorating China figures. Today, the ascent of the USD has overshadowed bond yields, but news China is moving from bad to worse as seen in both first and second tier data on consumer demand, manufacturing and imports. Case in point, today’s release of China trade figures showed a new record surplus in November, but aided by a 7% drop in imports– the fifth straight monthly decline over the last nine months. With China serving as the biggest source of demand for Latin and Asian EM, any pullback in imports, or a weakening yuan (or both) could become a veritable challenge for EM sentiment.

The chart below does not lie. Global disinflationary dangers will make it hard for US bond yields to regain 2.60% level any time soon. But any fresh strengthening of the greenback and headwinds on China may leave EM flat on their back.