KUCHING: US Federal Reserve is unlikely to rush tightening prematurely even as economic activity picks up, and this in turn could support emerging markets’ (EM) economic and financial sentiment, commented Moody’s Investors Service (Moody’s) in a report.
“A steady increase in long-term US treasury yields has raised the risk that market expectations of US interest rate normalisation will be brought forward, leading to a renewed and abrupt tightening of EM financing conditions.
“In our view, the likelihood of such a scenario is low for now, as the US Federal Reserve is unlikely to rush tightening prematurely even as economic activity picks up.
“A combination of ultra-low US interest rates and recovering US demand will in turn support EM economic and financial sentiment,” it said.
It pointed out that long-term US treasury yields have remained historically low. However, they have continued to firm in early 2021, with expectations of an earlier and more solid economic recovery owing to the roll-out of mass vaccination efforts and the prospect of continued fiscal support from the
Biden administration.
“The yield on the 10-year US treasury traded at around 10-month highs of 1.15 per cent in mid-January, while earlier in the month the 10-year US break-even rate – a proxy for long-term inflation expectations – breached two per cent for the first time since late 2018.
“Rapid increases in longer-term US treasury yields have often led to a sudden reversal in EM portfolio inflows as capital is diverted back into lower-risk assets,” it explained.
Nevertheless, it highlighted that the risk that higher US yields provoke a sudden stop of EM-wide foreign capital inflows is low.
“First, EM capital inflows turned sharply negative in 2020, so the starting point is much different relative to other reversal episodes.
“Economic and market sentiment toward global emerging markets, as proxied by our EM Financial Conditions Indicator (FCI), has only just returned to historical norms following pandemic-induced stress last year.
“Consequently, EM asset valuations do not appear overly stretched, reducing the risk of a sudden snapback in prices,” it said.
“Secondly, rising long-term yields also reflect growing market optimism around the pace of US economic recovery in the second half of 2021.
“A stronger US economy will lift demand for EM exports and reinforce the growth rebound taking place across most major emerging economies,” it added.
“Finally, the increase in US treasury yields – and the repricing of US interest rate expectations – is likely to remain gradual and orderly, given that US monetary authorities will likely retain a dovish policy bias even as additional fiscal stimulus is delivered,” it said.
“Indeed, we expect the Fed to calibrate policy gradually and transparently to minimise the risk of a sudden repricing along the maturity curve, a view reinforced by its adoption of an average inflation targeting framework last year.
“Moreover, alongside other central banks, the Fed will also seek to ensure sufficient dollar liquidity, which will help to minimise stress in the financial markets,” it concluded.
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