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Frontier Nations Will Suffer The Most If The Fed Rate Rises To 6%, According To Analysts

Frontier Nations Will Suffer The Most If The Fed Rate Rises To 6%, According To Analysts
Emerging markets are facing their demons as traders speculate on whether the United States Federal Reserve will raise interest rates as high as 6%, a level that could kick weaker countries when they're down, while diverging global growth paths and China's reopening may cushion some of the blow for the larger ones.
Expectations for where the Fed's terminal rate would peak have been skyrocketing: Markets are pricing in a 5.5%-5.75% range for September, with a near 50% chance of the band reaching 6% that month, according to the CME FedWatch tool.
The magnitude and speed of the move makes for uneasy reading for investors in developing stocks, bonds, and currencies, which have frequently buckled under rising global rates.
"The current repricing risk in the Fed's terminal fed funds rate to perhaps 6% in a short period of time is in the context of (the) response to inflation running stubbornly well-above target in a weakening global GDP growth environment," Satyam Panday, chief emerging markets economist at S&P Global Ratings told Reuters.
"This mix is generally a net negative for emerging markets."
25 basis point increments were anticipated for future Fed rate increases, but on Tuesday, Fed Chair Jerome Powell reopened the discussion to a faster tempo. The monthly U.S. jobs report for February will give markets more data to consider, so few anticipate a smooth ride for the rest of the week.
In a note, UBS strategist Manik Narain predicted that if the Fed increased interest rates to 6%, the Indian rupee, the Chinese yuan, the Philippine and Chilean pesos, as well as the Chilean peso, could all weaken by as much as 5%.
According to a recent Barclays analysis, an increase in interest rate volatility of 50 basis points would be more unstable initially because it "would typically be accompanied by EM FX underperformance, which could lead to a further leg up in EM rates."
The dollar will likely weaken once the terminal rate stabilizes, according to JPMorgan analysts, but a 50-basis point Fed rate hike "would be a regime-shift in favor of outsized USD-strength."
Sharply rising rates will likely have the biggest impact on frontier markets, according to Sahil Mahtani, multi-asset strategist at investment firm Ninety One.
According to analysts at Tellimer, the number of smaller, riskier emerging markets where investors demand a premium of 10 percentage points or more over safe-haven U.S. Treasuries has remained largely stable at around 30 countries. These nations, which also include Pakistan, Kenya, and Egypt, are essentially shut out of the capital markets.
Local fixed-income markets, however, are also expected to feel the pinch in larger developing economies. According to UBS, the most vulnerable short-term rates are those in Chile, India, Poland, the Czech Republic, and Hungary, where inflation is still high and the Fed rate is 6%.
Investors were forewarned when flows to EMs spiked in January but slowed to a crawl in February. According to Citi data released on Monday, capital outflows resumed last week, with hot money, or speculative capital, leaving Asia and Latin America while real money left emerging Europe, the Middle East, and Africa.
Investors, particularly those focused on the equities market, may believe that China's reopening will partially offset the impending recession in the United States and some of the historical impact of Fed rates on emerging markets.
Following two years of a combined 26% decline, emerging market stocks (.MSCIEF) are only up 2% this year, broadly lagging developed market peers. According to UBS, in the event of a 6% fed funds rate, Chinese equities could offer a haven.
According to Nuno Fernandes, a New York-based portfolio manager for GW&K's Emerging Wealth Equity Strategy, investors can't "look at the textbook of history" because the emerging market universe is more Asia-centric than in previous sharp increases of global rates.
China makes up almost a third of the benchmark for emerging market equities and close to 5% of the benchmark for fixed-income hard currencies, which is positive for the asset class.
"Investors are conditioned to think that EM tail risk emerges in the context of aggressive U.S. rate hiking cycles," said Ninety One's Mahtani. "I think it's dangerous to say this time is different, but it feels like it's not that mechanical this time."

Christopher J. Mitchell

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