Morgan Stanley (MS) warned emerging-market investors that developing nations may fail to deliver the interest-rate cuts they have priced in as a more hawkish Federal Reserve raises the prospect of a stronger dollar.
The caution comes amid the rising popularity of rate receiver trades — which make money when borrowing costs drop — touted by banks from Goldman Sachs Group Inc. (GS) to Citigroup Inc. (C) The rush to lock in current yields is also happening in another corner of the market — carry trades — where wagers funded by short-dollar positions are bringing in the best first-half returns in six years.
But according to Morgan Stanley strategists James K Lord and Ioana Zamfir, emerging-market central banks may act more cautiously the further the Fed pushes rates higher. The bank recently increased its forecast for the Fed terminal rate and told its clients of its bullish view on the dollar. Money markets have locked in expectations for a 25 basis-point rate hike and assign about a one-third probability of a further quarter-point increase by the US central bank.
“While low inflation might justify a steep easing cycle in emerging markets, and even keep real rates steady, the sharp narrowing in nominal interest rate differentials that this implies would likely leave EM local markets vulnerable to shocks,” the strategists wrote in a note. “This outlook might help to slow the pace of cuts, though there is more debate to be had about whether it simply pushes out the same terminal rate.”
Emerging economies, which started rate hikes about a year before the Fed, are increasingly signaling a dovish policy pivot, even as US policymakers remain hawkish. While monetary tightening has paused in a number of countries from India to Mexico and Taiwan, some like Hungary have already started cutting. The moves are backed by high real yields in the developing world, especially in Latin America.
A Bloomberg index that measures carry-trade returns from eight emerging markets climbed 4.8% in the first half.
“Increasingly stronger downward momentum in regional consumer-price index remains supportive for lower rates,” in Latin America, the strategists said. “However, the outright level of US rates could pose some constraints around the pricing for the near-term pace of cuts across the board, triggering some flattening” in the yield curve, they said.
Besides rates, growth dynamics in the world’s largest economy could also help to unwind risk-on trades, the strategists said. In that scenario, currencies that benefited the most from strength in the US economy — such as the Mexican peso — would be the most vulnerable.
“Should US data roll over to indicate a higher risk of recession, then all three of the world’s major economic blocs – the US, eurozone and China – would be facing very challenging growth conditions,” they wrote. “We suspect this would be enough to drive a repricing of global risk assets and an unwinding of FX carry trades.”
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