For those anxious to see if the turbulence that has flared on emerging markets will deepen, the relative performance of bonds sold in local currencies and those issued in “hard” currencies, mostly dollars, is worth watching.
Local currency bonds have been standout performers among EM assets, with JPMorgan’s benchmark GBI-EM index gaining 38 per cent in the two years to January. They were jolted in February when the dollar changed direction after weakening for two years and expectations of U.S. interest rates turned more hawkish. Yet they recovered most of their losses and held steady — until last month.
From the third week of April, prices for local currency EM bonds had a steep drop, shedding more than 5 per cent. This coincided with a fresh burst of dollar strength and a growing perception that while U.S. economic growth remains robust it may have peaked in emerging markets and elsewhere.
Hard currency EM bonds offered investors less spectacular returns in the two years to January and recovered less well from the February sell-off. But they had not fared as badly as their local currency equivalents during the recent ructions until last week, when they took a sudden dive.
Those declines have eased in the past couple of days, but further losses for the hard currency bonds would not be auspicious.
In “normal” times, as investors sell local currency bonds, you might expect them to put some of the proceeds into hard currency bonds that offer protection from swings in exchange rates. This happened to some extent this year. But not last week.
If investors continue to pull money from EM bonds across the board it will be a sign that perceived risk in emerging markets has taken a step up.
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