Are the effects of higher UST rates necessarily negative on emerging economies, or can the spillover effects of stronger US growth compensate for tighter financial conditions?

US financial conditions have tightened since late February into March. This has had a negative impact on EM rates and FX. A large part of tightening in US financial conditions has been driven by the move in US rates. The United States is running highly accommodative monetary and fiscal policy. This is likely going to help US growth surprise on the upside compared to the rest of the world. A faster vaccination schedule will also help with a quicker reopening of its economy. At this juncture EM central banks are caught between a slower recovery in domestic growth, higher external commodity prices and poor base effects for inflation. Many EM countries do not have the fiscal room to continue to provide fiscal stimulus.

EM central banks with higher credibility (Mexico, Colombia, Chile) will be able to continue to keep rates low should core inflation remain contained. Meanwhile, EM central banks with lower credibility (Brazil, Turkey) would be forced to hike rates to try and contain inflation expectations and reduce the risk of inflation pass through. For most of EM countries we expect base effects to become supportive of inflation by May 2021.

For EMFX the improvements in terms of trade have not led to a real appreciation vs the dollar to date. This has been the theme since the COVID shock in 2020, apart from Q4 2020. This has led to further reserve accumulation by EM central banks via improvements in trade balance. We also expect improvements in outbound tourism from US to further help external accounts in Mexico, Central America and the Caribbean.

Looking into the second quarter, we expect the pace of vaccinations to pick up in rest of the world. The effects of US fiscal stimulus on EM is also going to be a clear positive driven by US consumption and investment. Some of the supply chain disruptions and bottle necks created by increased COVID cases around the world should ease and mitigate price pressures.

Markets are indeed pricing in some probability of excess fiscal stimulus in the US leading to overheating of the global economy and ultimately shortening of the global expansion cycle. While this is not our base case, the risks are worth monitoring.

We remain constructive on Mexico, Chile, and Colombia both in the FX and rates space as we see room for rates to grind tighter and FX to appreciate.