Running out of Reasons to Be Cheerful for Emerging Markets

The emergence of an inverted U.S. Treasury yield curve is a bad sign for emerging markets

By Jacky Wong

On Friday, investors woke up to the fact that a dovish Fed may mean the U.S. economy is weaker than expected.
On Friday, investors woke up to the fact that a dovish Fed may mean the U.S. economy is weaker than expected. Photo: ritchie b tongo/Shutterstock 


A dovish Federal Reserve has given emerging markets a lift this year. Now investors are starting to realize the Fed’s change of heart may not be all good news.

Until recently, stocks, bonds and currencies in emerging markets had all risen this year. The MSCI Emerging Markets Index is still up 10%, partially reversing last year’s 17% loss. The Fed helped kick investors into risk-taking mode when it signaled in January that it was done raising interest rates.

That helped spur a resurgence of so-called carry trades—borrowing in dollars to earn higher returns in emerging-market assets—leading to stronger EM currencies, especially high-yielding ones such as the Indian rupee and the Mexican peso. The Fed’s announcement last Wednesday that there would likely be no more rate increases this year fueled further gains in EM assets.



That is, until Friday, when investors finally woke up to the fact that a dovish Fed may mean the U.S. economy is weaker than expected. The 10-year Treasury yield dropped below that of the three-month on Friday for the first time since 2007. Such a yield-curve inversion preceded each of the past seven U.S. recessions. EM assets have since taken a hit: The Mexican peso fell 1.6% on Friday, while Asian stocks plunged on Monday.


To be sure, a yield-curve inversion for one day isn’t a guaranteed predictor of bad things to come. It does, though, add to a worrying pileup of bad news for the global economy that investors have been all too ready to ignore this year. Many have also seemed to assume that another Beijing stimulus would stoke the Chinese economy back to health. But significant monetary policy easing there has failed to translate into higher lending to the private sector: Beijing may now have to enact a U-turn on its shadow-banking crackdown. Meanwhile, the uncertain outcome of U.S.-China trade talks still looms.

Expectations of lower U.S. rates juiced up emerging markets. As investors recalibrate what those lower rates really mean, reasons are mounting to believe the best may be over for EM this year.

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