Investors in emerging markets always pay close attention to the Fed. Now, this makes them very nervous.

Fed Chairman Jay Powell insisted that the Fed believes that the recent surge in consumer price inflation is temporary and will not risk stifling the economic recovery by prematurely tightening monetary policy.

But the signal is mixed. The hawkish officials of the Federal Open Market Committee of the bank suggested that the Fed should reduce its support to the economy through asset purchases as early as September and raise interest rates as early as next year.

For investors in emerging markets, this is a game changer.

“The Federal Reserve has greatly accelerated the dialogue, from just considering inflation to raising interest rates,” said Phoenix Cullen, an emerging market strategist at Societe Generale in London. “This caused very difficult months when the market readjusted… The U.S. dollar will go higher before the first interest rate hike is realized.”

A rebound in the dollar causes trouble for fund managers investing in local currency stocks or bonds in developing countries because it erodes the dollar value of these bets.

For most of the pandemic, the U.S. dollar weakened against the currencies of major U.S. trading partners. But since the recovery at the end of last year, things have changed. After experiencing severe volatility in January and May, the benchmark DXY dollar index has risen by more than 3% so far this year.

At the same time, emerging market stocks have stagnated. They are off to a good start this year, but the benchmark MSCI Emerging Markets Index is now more than 7% below its peak in mid-February.

Fear is more. If the Fed raises interest rates to combat inflation, it will not only strengthen the U.S. dollar; it will also increase the attractiveness of “safe” assets such as US government bonds, making investors less willing to look for higher-yielding and riskier assets elsewhere. . This means that even emerging market assets denominated in U.S. dollars or other foreign currencies, such as sovereign bonds and corporate euro bonds, will be affected.

China’s economic recovery is starting to lose momentum, adding to the difficulties for investors. As the second largest economy in the world after the United States, and over the years because of its huge demand for commodities and other export products, it has become an important driving force for developing economies. China has the same impact on the performance of emerging market assets as the United States. Big-some analysts will say more.

“In the context of China’s economic slowdown, this has undoubtedly raised concerns about how fast the global economy will recover,” Karen said.

An indicator of the global outlook can be seen in the commodity market. Prices have been rising in the past year, oil prices have recently returned to pre-pandemic levels, and copper prices have hit a record high. But they are relaxing now.

Simon Quijano-Evans, an economist at Gemcorp Capital and a long-time emerging market expert, believes that oil prices have peaked and food prices will rise in the coming months.

In his view, soaring commodity prices and consumer price inflation are short-term shocks that investors in emerging markets are accustomed to, but most investors in developed markets have never experienced such shocks.

“For me, there has never been a deflationary story,” he said. “This is more like a one-off shock. For developed market participants, the shock is greater than for emerging market participants.”

He believes that optimism about the U.S. economy is mainly driven by the introduction of vaccines, and as the Delta variant and other variants become problems in the United States and the world, the introduction of vaccines has slowed recently. This is reflected in the US Treasury bond yield, which rose in the first quarter of this year as investors sold safe-haven assets, but has since fallen.

The level of hawkishness of local debt in emerging markets was the same as in 2018, when the Fed not only raised interest rates, but also raised interest rates more than expected.

At the same time, “the Fed is still buying bonds on a large scale. Although the Fed’s policy has not changed, as long as these problems occur, yields will face downward pressure,” he said.

He said that in the second half of this year, investors will have to be cautious in investing in local currency assets in emerging markets. In the context of the upcoming changes in Fed policy, there will be more one-off shocks from inflation and other aspects.

However, Murat Ulgen, head of emerging market research at HSBC, said that investors may be wrong to pay too much attention to the Fed.

He believes that compared with the 2013-14 “shrink panic” shock, many emerging economies are more able to withstand the interruption of the Fed’s withdrawal from the stimulus plan, when the prospect of their weakening support at that time severely hit emerging market assets. At that time, the fundamental situation of central bank reserves and external payments was much worse than it is now.

In 2013, emerging market policymakers were surprised by the Fed’s announcement of an imminent policy change. This time, many people themselves have begun to tighten their policies. Last week, Chile became the latest in a series of emerging market central banks to raise interest rates in the face of inflation.

“This time emerging markets are trying to lead the Fed,” Urgen said. “The level of hawkishness of local debt in emerging markets is the same as in 2018, when the Fed not only raised interest rates, but also raised interest rates more than expected.”