The hawkish Fed - Nothing good for emerging markets

The Fed's hawkish policies of raising rates will have more than just an impact on the US economy it will impact emerging markets. We have already seen a significant divergence between EM and US equities as measured by the difference between SPY and EEM. There has historically been a strong negative link between increases in the Fed Funds rate and EM, but it looks as though this relationship has not been as strong over the last two decades. Work from the Fed shows there is a reason for this difference in sensitivity. See "Are Rising U.S. Interest Rates Destabilizing for Emerging Market Economies?".

The analysis shows that there is a difference in the EM response based the reason for the rate rise. If rates are increasing because there is higher economic growth, there will be limited impact on EM. On the other hand, if the rate increase is caused by a hawkish Fed policy to combat inflation, there will be a strong negative impact. 

Growth news is different than monetary news. Growth news occurs when SPX index returns and 10-year Treasury yields move in the same direction after a FOMC or employment announcement. The FOMC announcement or employment data conveys monetary news if equity returns and Treasury yields move in opposite directions. Based on this classification, it can be determined what will be the reaction in EM through looking at panel data for a large set of EM countries.

If the Fed is trying to cut aggregate demand, there will be a spillover effect to other countries. This current environment is more like the early 1980's than anything seen in the last two decades. While the test is over short horizons, it provides investors some insight on what to expect around the globe. This time will not be good for EM investors.