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Specter of Treasury Rout Comes at Grim Time for Emerging Markets

(Bloomberg) — Emerging markets haven’t looked so exposed to climbing U.S. yields for almost half a decade.

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The correlation between currencies in the developing world and short-term Treasuries increased to around the strongest level since 2017 last week. It underscores the potential fallout for the asset class if traders continue to price in a faster-than-expected tightening drive by the Federal Reserve.

Sings of stress are already showing. Emerging-market stocks just capped their longest string of weekly declines in more than two years, while bond funds in the space registered $2.8 billion of outflows in the week through Sept. 29, the biggest exodus since March, according to data from Bank of America. Investors also withdrew money from exchange-traded funds that buy developing-nation stocks and bonds.

That comes as the yield on two-year Treasures briefly spiked to levels last seen since the start of the pandemic over a year ago.

Unlike a selloff in the Treasury market earlier this year — spurred by optimism over a flood of monetary and fiscal stimulus — the impetus this time is the risk of accelerating inflation, and increasingly hawkish central banks. That’s even as the momentum for growth and assets across the developing world begins to fade.

In the event that developing-market yields “prove more responsive to inflation over the last three months of the year, this would be bad news for EM FX, which posts its worst returns when U.S. rates rise and EM equities fall,” strategists including George Saravelos at Deutsche Bank AG wrote in a report to clients last week.

It’s a stark contrast from just a few months ago, when the likes of Goldman Sachs Group Inc. and Lazard Asset Management called the end of two decades of underperformance for emerging-market stocks against their developed peers.

For State Street Corp., a jump of more than 50 basis points in 10-year U.S. yields over three months would be a “sign of caution,” while William Blair Investment Management LLC, said a 30-basis-point increase over the coming weeks would be enough to trigger outflows.

Any shock to 10-year yields driven by concern over the outlook for consumer prices or policy could be greater than previous blows seen this year, according to a Bloomberg study.

Traders are already bracing for a slew of inflation releases this week from developing economies, including South Korea, Russia and Mexico. Last month, a Citigroup Inc. index of economic surprises in the emerging world fell below zero for the first time in over a year, meaning data releases have been worse than expected.

The bearish backdrop could hardly have come at a worse time for emerging-market investors, which have been bruised by the fallout of China Evergrande Group’s debt crisis and Beijing’s regulatory crackdown on key sectors including technology.

Emerging-market stocks extended losses on Monday in New York, alongside weakness in 10 of 24 developing currencies tracked by Bloomberg.

Among the most exposed local-currency bond markets are those of Turkey, Indonesia and Mexico given their fiscal and current-account deficits, lower foreign-exchange reserves, according to Emily Weis, a macro strategist at State Street in Boston.

Still, a lot depends on the pace of any selloff. While the market would simply digest a steady increase to 1.75% in 10-year U.S. yields by year-end, the “markets should expect a bumpy ride,” if it hits 1.70% in the coming weeks, Mark Holman, chief executive officer at TwentyFour Asset Management, wrote in a note last week.

These are the events and data to look out for this week:

  • Money managers will monitor inflation readings from around the world for clues on what pressures may be weighing on central bankers

    • A reading of South Korea’s CPI inflation on Tuesday will probably linger above the 2% target in September, bolstering the case for another central-bank hike

    • In EMEA, pickups are expected in September inflation numbers released for Turkey on Monday and Russia on Wednesday

    • Mexico’s headline and core inflation probably extended their uptrend in September, which could add pressure on policy makers to keep tightening

    • Traders may see a decline in Chile’s headline inflation due to base effects, according to Bloomberg Economics

  • Colombia will release September central bank meeting minutes on Monday, which investors will scour for clues on the tightening path ahead

  • Peru’s central bank is expected to raise rates on Thursday

  • Policy makers in India are expected to keep their key rates steady on Friday while reiterating an accommodative stance and paring back bond purchases, according to Bloomberg Economics

(Adds Monday’s EM market moves to 12th paragraph. Earlier added ETF flows in third paragraph. A previous version of this story was corrected to show inflation data in South Korea is due Tuesday.)

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