Return to normal interest rate environment stressing emerging markets says Schroders

20th June 2013

Policymakers believe the US economy is out of the emergency room but the return to normal interest rates will cause stress in emerging markets says Schroders head of global and international equities Virginie Maisonneuve. She adds that the US and Japan face a difficult balancing act when returning to this normal environment.

In a note issued this week (though just before the Bernanke announcement), she writes: “The normalisation in the US and Japanese bond markets away from an abnormally low interest rate environment is based on the premise of improved economic growth.”

In terms of QE, the note says: “We expect any withdrawal from quantitative easing in the US to be some time away, markets are already sensitive to signals from the Federal Reserve. The yield on the 10 year treasury recovered from 1.6% in early May to 2.2% in mid-June, a 14-month high.  In Japan, 10 year bond rates increased to over 0.9% at the end of May from 0.5% in early April.

“This should be taken by investors as good news: a normalisation away from quantitative easing in the US is a sign that decision-makers believe the economy is giving sufficiently positive signals that it can be taken out of the emergency room.”

In Japan, the markets were disappointed by the recent reform adjustments announced by Prime Minister Shinzo Abe, as the “third arrow” of Abenomics fell short of their target says Maisonneuve.

But the key is to wait for the upper house election in July and see if Mr Abe’s promises regarding an impactful second round of reforms remain in place.

In terms of other markets, she adds: “One must be aware of potential unintended consequences in the delicate balance of progress to normalisation in a global economy still under stress. In particular, it is important to monitor volatility in the bond markets and the high exposure to bonds in the financial world given that investors have stayed away from equities and given new regulations.”

She says there is also a potential for emerging market volatility.

“Emerging market economies, which for the most part have demonstrated stronger growth than their developed market peers since the beginning of the crisis, are feeling the impact of this normalisation.  This is happening via the fluctuation of their currencies versus the dollar and the yen, something that is especially true in the context of current account deficit economies.

“The potential for renewed interest for developed market yield and the potential sourcing of funds from emerging market debt vehicles and a weakening of demand is something that should not be ignored. We believe it will lead to pressure but not systemic risk at this point.

“Overall, one should use this volatility in emerging markets to accumulate positions in areas where prospects are stronger. For leaders in the US and Japan, while driving their own economies is already a difficult exercise, anticipating the impact those measures might have on the rest of the world is a delicate but crucial task.”

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