The Fed kept rates on hold in late July, and investors are increasingly expecting it to be very slow in raising interest rates in the near-term future.
“We expect the next hike will be in June next year. We postponed this from predictions of a hike in September this year following Brexit, which increased global economic uncertainty, amongst other factors,” said Jakob Christensen, chief analyst and head of EM research at Danske Bank.
Even when the Fed does next hike rates, it will likely be a relatively small 25bp hike similar to the increase earlier this year.
The impact of a future rate hike on EMs could be significant. The EM rally that the markets are experiencing is down to the fact that the Fed has held off on raising interest rates.
“If the Fed does signal that it is ready to continue the hiking cycle, it will have a negative impact on the usual suspects.”
Those countries that have not been able to reduce their external imbalances when rates were low will feel substantial pressure.
South Africa continues to have very weak external balances even though the rand has significantly depreciated. It currently stands at 13.2945 to the US dollar, according to Bloomberg.
Christensen also noted that there were some structural factors that were preventing an improvement of the country’s external balances, such as high foreign interest payments.
Turkey has also not seen a significant improvement in its external balances. Part of this was from the shock from Russian sanctions (which look to soon be removed), but there are again structural factors that are preventing an improvement in the external balances.
“We are still looking at a deficit for Turkey of 3 or 4% of GDP, which is quite substantial.”
Given that economic prospects in EMs look better, private consumption is likely to begin to grow more strongly, which will feed into imports.
This could lead to some cyclical increases in the current account deficits of certain, notably Asian EMs, such as India.
However, due to very low or negative yields in the 10-year government bonds of DMs like the US (1.54%), Germany (-0.10%), Switzerland (-0.60%) and Japan (-0.11%) Bloomberg data shows, investors could continue to hold EM fixed-income assets despite a Fed hike.
“Even if we have a rate hike in September, if it is a single hike over a long period of time then I do not think there will be a major EM selloff as yields are very low across developed markets,” Christensen said.
However, it depends on the signals given out by the big central banks he continued.
“It is unlikely to be a major issue if there is a rate hike every 6 months, but if central banks are prepared to hike every quarter then we are likely to see more pressure on EMs.”