Emerging markets and US rate shocks - Easy dollar credit makes for better EM bond returns

Whether we like it or not US monetary policy impacts the rest of the world. A dollar-dominated world means that tight or loose monetary policy in the US will affect the rest of the world, especially emerging markets. There are benefits with a dollar world but also responsibilities. Investor have to track US rate shocks and right now a lower of rates will spill-over to EM rates and equity returns. This is especially the case when the rest of the world is slowing and there is a monetary policy disconnect.  

The US and EM link is documented in one of the key papers at the Federal Reserve Bank of Kansas City's Jackson Hole Economic Policy Symposium, "US Monetary Policy and International Risk Spillovers" by Sebnem Kalemli-Ozcan.  We have posted a blog that global r-star impacts US rates (see Low r-star as a global issue - Implications for global asset management), but US policy shocks impact other countries especially emerging markets.

While there are limited rate differentials in developed countries, there is more dispersion in rates between the US and EM countries. There are greater risk differentials and these rate spreads will increase with global risks as proxied by the VIX. The VIX serves as a global risk sentiment. A shock to US rates will impact sentiment across EM rates. Tighter (looser) monetary policy in the US will increase (decrease) spreads in EM rates. More US credit will affects risks and global funding. 

Declines in US rates will carry-over to EM risk premia through declining rate differentials. In a weak EM environment, a Fed policy of cutting rates will tighten premia and offer better global bond opportunities. For 2019, we have seen emerging market bonds outperform US and DM bond portfolios and the international AGG has outperformed the US AGG index even with a slight dollar increase. EM bonds will be attractive in a looser Fed monetary policy environment.