"High US Treasury Yields + Strong Dollar" Test Emerging Markets

Morgan Stanley believes that although emerging market fixed income and foreign exchange assets are under pressure amid sharply rising US Treasury yields and a strengthening dollar, an orderly adjustment is more likely than a sharp sell-off. However, spreads are no longer cheap, and investors should wait for valuations to overshoot before increasing positions.

Soaring US Treasury yields, expectations of two more Federal Reserve rate hikes, a stronger dollar, and persistently high oil prices—this combination would typically cause emerging market assets to significantly underperform. Yet this year’s reality has proven surprising: while returns have weakened, the adjustment process has been exceptionally orderly, and emerging market assets continue to outperform on multiple dimensions.

James Lord, Head of Emerging Markets FX Strategy at Morgan Stanley, points out that at present, the combined influence of oil prices, US Treasury yields, and the US dollar accounts for about 55% to 60% of the return variation in both hard currency (i.e., bonds denominated in US dollars or other major international currencies) and local currency (i.e., bonds denominated in local currencies) emerging market fixed income, whereas prior to the outbreak of the Iran conflict, this proportion was only about 25%. This means that the sensitivity of emerging markets to external shocks has increased significantly.

Morgan Stanley’s baseline judgment is: from the current position, emerging markets are more likely to enter a period of low returns rather than experience disorderly sell-offs. However, as the cushion provided by spreads is exhausted, market vulnerabilities should not be ignored if global risk events occur again.

Local Currency Bond Market: Inflows Outpaced Returns, with the Widest Divergence in a Decade

Structural concerns in emerging market local currency assets are building. James Lord notes that the carry of current emerging market FX indices is at a historical low, while flows into local currency bonds have significantly outpaced actual returns.

Data shows that over the past three months, returns from local currency emerging market bonds were around the 45th percentile in history, while inflows hit the 90th percentile; on a calendar year basis, this divergence is the largest since 2013.

Morgan Stanley believes that a slowdown in inflows is nearly a foregone conclusion. However, the resilience displayed by the market thus far indicates that investors remain confident in the improvement of emerging markets’ fundamentals.

The key support for this judgment is monetary policy credibility. Real interest rates at several emerging market central banks are at elevated levels, particularly in Brazil, Colombia, and Turkey, providing a certain degree of buffer for the market. The firm notes:

Carry trades in Egypt and Nigeria remain attractive due to high real interest rates, solid fundamentals, and ongoing reforms, and Morgan Stanley maintains its bullish stance. Hungary stands out as ongoing structural improvement and convergence with the euro area are likely to drive lower yields and a weaker EURHUF.

Sovereign Credit: Spreads No Longer Cheap, Buffer Running Thin

Compared to the local currency market, the performance of sovereign credit is even stronger. Since late June, US Treasury yields have risen by nearly 90 basis points cumulatively, yet emerging market sovereign credit spreads have barely moved year-to-date. Historically, when Treasuries sell off by more than roughly 50 basis points, EM spreads typically widen accordingly—this time, however, the market’s reaction has clearly lagged.

James Lord attributes this to three main factors:

First, compared to previous risk-off cycles, emerging market fundamentals are now more robust—current account imbalances are within controllable ranges and policy responses remain largely orthodox;

Second, near-term debt maturity pressures are much more manageable than in 2022;

Third, technical factors provide support—the supply of emerging market sovereign bonds remains moderate, while large-scale issuance of US corporate bonds has reduced position concentration for cross-market investors in emerging markets.

However, spreads are no longer cheap. Current emerging market sovereign spreads are around 200 basis points, roughly in line with Morgan Stanley’s year-end baseline forecast, and the average spread matches US corporates with similar ratings. This means that should another global shock occur, the market essentially has no extra cushion.

In view of this, Morgan Stanley, while acknowledging increased challenges, still chooses to maintain its spread forecast. The logic is that higher Treasury yields partly reflect economic resiliency rather than pure risk aversion; inflation is still declining; higher all-in bond yields will eventually attract demand back; and a notable drop in oil prices would simultaneously ease inflation pressure and the outlook for further Fed rate hikes.

Despite the relatively mild base-case scenario, Morgan Stanley’s strategic recommendations remain defensive.

James Lord notes that for currency pairs highly sensitive to global factors and with low spreads, it is reasonable to tactically hedge for further potential US dollar appreciation, with the South African rand (ZAR) and Mexican peso (MXN) being particularly worth watching.

Additionally, Morgan Stanley advises investors to pay attention to the outcome of Brazil’s presidential election. The bank believes that markets have yet to fully price in tail risks under pessimistic scenarios; if the results point to expectations for fiscal consolidation, both fixed income and equities are likely to see substantial upside.