The dollar rally is punishing emerging-market bonds, after year of record issuance – marketwatch 3 gases in the air


“The dollar remains the single most important consideration for EM finances,” said James McCormack, global head of sovereigns for Fitch Ratings. “A stronger dollar will be associated with a weakening of EM economies’ external balance sheets.”

Borrowers weren’t ignorant of the risks but, for some, the allure of selling debt in dollars was too attractive to dismiss. Issuing dollar-denominated debt instead of government paper in local currencies can often result in cheaper borrowing, as risk-averse investors paid a premium for receiving interest payments in the more stable greenback. That’s because volatility in emerging-market currencies can wipe out the gains accrued from the high yielding, emerging-market bonds.

McCormack said emerging-market bonds were particularly sensitive to a strengthening dollar as it forced their central banks in those countries to drain foreign-exchange reserves to halt local currencies from sliding against the buck. However, depleting those accounts means fewer dollars available for interest payments, pushing investors to demand richer yields as compensation for holding riskier debt.

The New York Federal Reserve’s custody holdings of Treasurys, which often reflects foreign-exchange reserves held on behalf of non-U.S. central banks, has dropped more than $60 billion to $3.04 trillion as of May 9, from a peak of $3.11 trillion in March. That suggests that foreign central banks, indeed, are using dollars to buy up local currencies, lifting their values.

In the attached chart from Fitch Ratings, credit ratings for emerging-market, government bonds move in tandem with the dollar’s movements. That reflects the amount of borrowing done in a foreign currency by emerging-market entities. Total issuance of U.S. dollar-denominated bonds by emerging countries doubled to more than $11 trillion between the end of 2007 and September 2017, according to the Bank for International Settlements.

“Given the propensity of emerging market [corporations] to also fund themselves in the U.S. dollar,” corporate debt has also faltered as dollar-inflated borrowing costs eat into profit margins, said Solomon Tadesse, cross-asset strategist at Société Générale.

Strong global growth had kept a steady inflow of money moving into emerging-market assets as investors turned away from U.S. valuations considered elevated. Issuers, in turn, took advantage of the pickup in demand, issuing more than $450 billion of bonds in 2017, an all-time annual record, according to CreditSights.

Governments and central banks from countries like Argentina worked hard to narrow their current-account deficits, which roughly matches the size of the trade deficit, and steadily accumulated foreign currency reserves. The current-account deficit for emerging market economies has narrowed to $26 billion in 2017 from $91 billion in 2016, according to International Monetary Fund data.

Yet some expect the dollar’s rally to be short-lived. A combination of the U.S.’s yawning trade deficit and a widening budget deficit is likely to cap the dollar’s rebound this time around, said Lisa Shalett, head of investment and portfolio strategies at Morgan Stanley Wealth Management.