Heres’s Why The Plunge in the Indian Rupee Matters To You
In May and June, when markets initially declined on the prospects of Fed tapering, I pointed out to my clients two very important things we all needed to keep in mind as the market started to adjust to the reality of higher interest rates in the future.
First, it’s the pace of the rise in interest rates that’s important, not the absolute level. So, the stock market can rally along with interest rates, as long as the pace of the rise in interest rates isn’t too fast.
Second, emerging-market debt is now the “leading edge” of any potential market turmoil, as that sector has replaced Europe as the “weakest link” in the global financial system. Stable emerging debt markets are a pre-requisite for any sustainable rally in stocks.
With that in mind, after we saw an initial shock in May/early June, the pace of the increase in interest rates leveled off, and emerging-market debt stabilized—which allowed the stock market rally to new all-time highs.
But, over the last week, emerging debt markets have quietly begun to break down again as the pace of the rise in interest rates here in the U.S. has quickened substantially. (The 10-year yield went from a low of 2.55% last Monday to a high of 2.899% yesterday.)
In reaction to that acceleration, emerging-market bonds—as measured by the PowerShares Emerging Markets Sovereign Debt ETF (PCY) and the iShares JPMorgan USD Emerging Bond Fund (EMB)—have declined sharply, and are now dangerously close to breaking down.
As a refresher, I’ve included an excerpt from the June 12 Report that explains why emerging-market debt poses a potentially significant risk to the market (below):
Why The Plunge In the South African Rand Matters to You (June 12th 7:00’s Report).
“Away from the yen, the other focus in the currency markets was on the implosion we’re seeing in emerging-market currencies. The Indian rupee hit another all-time low vs. the dollar. The Brazilian real and South African rand hit four-year lows vs. the dollar, and even strong currencies like the Mexican peso got hit yesterday.
“The reason for the weakness is this: Since the Fed went to 0% interest rates and round after round of QE, investors have moved into higher-yielding emerging-market currencies over the past few years.
“Now with the Fed potentially ‘tapering’ and interest rates in the U.S. rising, investors are reversing the trade. They no longer need to take the risk of being in emerging markets, as rates are rising here at home.
“That’s causing the currencies of those emerging-market countries to drop as investors sell their bonds and reconvert those investments back into dollars. Basically, ‘doomsayers’ are saying the world’s major central banks, led by the Fed, have created a bubble in emerging-market credit, and now it’s popping.
“The question I’m sure you’re asking right now is ‘Why the hell do I care about emerging-market credit?’ Well, you care because, as these currencies and bonds plunge, it’s causing losses in the leveraged hedge funds that have put the trade on. That’s causing them to liquidate other holdings to cover the losses (like stocks and gold, for instance).
“Point being, you should care for the same reason everyone should have cared when the mortgage-backed security markets started blowing up in ‘07, ‘08 and eventually led to the takedown of Bear, Lehman, etc. I’m not saying it’s the same thing here at all—but it’s the leverage and the huge declines that are making people nervous.
“So, while it’s not a disaster yet, this unwind out of emerging-market debt and currencies is having an effect on all asset classes. It’s not anywhere near 1998-style proportions yet (the emerging-market debt crisis), but it is unnerving investors, and weighing on other risk assets. Bottom line is watch PCY and EMB, the two emerging-market bond ETFs. Emerging-market bonds need to stabilize in order for equity markets to calm down a bit.”
Bottom Line
The market dynamic may have changed a bit Monday, and for the worse. The acceleration in the rise in interest rates is causing another round of turmoil in the emerging markets. And, as stated, a stable EM debt market is a requirement for any rally in the global equity markets. If emerging-market bonds can’t stabilize at these levels and they take another leg lower, then stocks are going to follow them down, regardless of the positive economic momentum in Europe China, etc.
My optimism on equities has been consistently hedged with the statement “if the macro environment stays relatively clear.” Well, an emerging-market currency/debt crisis doesn’t constitute a “relatively clear” macro horizon, so emerging markets need to stabilize before equities can resume their rally.
Keep an eye on PCY and EMB—if they break down to new lows, that’s a sign to get defensive with regard to domestic and international equity exposure.
I wouldn’t sell yet as EM bonds haven’t made new lows, and keep in mind the EM inspired dip in June turned out to be a buying opportunity. But, this is a potential game changer if we get a sustained move lower in the emerging markets, so I’d certainly get a plan together about just how I want to de-risk if EM bonds break down further.