Link between the US and emerging market bonds

From the IMF direct blog, there is some interesting work on the link between US rates, the taper tantrum and emerging market bonds. Ex post, many should have seen this coming, but it shows how the market got caught on the wrong side after the taper talks.

Figure 1 shows what caused the huge loses in fixed income over the last year from the taper tantrum. The beta for emerging market bonds went from a low of below 1 to levels that were double. The risk exploded for emerging markets when the market was looking to be relatively safe. There was a major reaction to the fact that Fed liquidity would start to be reversed. This has actually be the story we have see for decades. If there is Fed tightening, there is a strong reaction by emerging markets. Many thought this time would be different. In reality, history has repeated itself. The difference is the reaction has been based on anticipation of a policy change not a true change. Now that the taper is in place, emerging market bonds have calmed. 

Figure 2 shows the rate increase was associated with real rates moving off of their lows. Less global liquidity and emerging markets in general will see a revision upwards. Of course, real rates were starting at multi-year lows so the bias was for an upward move given the right signals. It is hard to believe there was much more movement on the downside for real rates.

Finally, the third figure shows that high inflation countries saw the biggest change in yields and the big revision in exchange rates. The countries that were poorly managed suffered the most.

The story of potential tighter liquidity causing an increase in real rates and hurting those which had poorer country economics follows a sense of logic. Surprises do occur, but the reaction should be anticipated.