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European economist Frederik Ducrozet's hypothetical quote, "U.S. to EM: Tapering is our policy, but your problem," provides an excellent synopsis of the current carnage in developing world debt and currency markets. In 2011 and 2012, a desperate hunt for yield attracted massive investment flows into emerging markets bonds. Now, amid Fed tapering fears, the process is in reverse – and at maximum speed.
This chart tells the story. The blue line shows the spread – difference in yield – between U.S. Treasuries and emerging markets bonds. The red line shows the market cap of the iShares JPM Emerging Markets Bond (EMB) exchange-traded fund, which is the largest emerging markets bond ETF. (I'm using this ETF as a proxy for asset growth in the sector.)
In late 2011, yield-starved investors noted the 4 per cent yield pick-up available in emerging markets debt and began piling into the sector. The iShares ETF assets (this includes changes in the market value of the portfolio) climbed 62 per cent to $5.4-billion (U.S.) in the 12 months after August, 2011.
The 2012 peak in the Treasury versus EM bond spread occurred in early June (at 4.4 per cent) and that's when things started getting overheated. Investor interest exploded, driving the iShares ETF assets $2-billion higher, to $7-billion, by January of this year.
But the inflows also increased the price of emerging markets bonds, driving their yields lower and making them less attractive as an alternative to developed market bonds. On Jan. 1, 2013, the average EM bond yielded only 2.5 per cent more than Treasuries. That's when the selling began.
Investors have been removing assets from the emerging markets debt sector throughout the year. The process accelerated in May when Fed chairman Ben Bernanke hinted at the end of QE3, the third round of quantitative easing. The subsequent higher Treasury yields offered stiffer competition for EM bonds. At this point, the market cap of the EMB ETF has declined 45 per cent from the 2013 high.
The ETF sector is only part of the story. Fixed income mutual funds, pension funds and hedge funds are also pulling their money out of emerging markets as fast as they can. The monetary amounts are enormous, forcing the central banks of India and Brazil to enact desperate measures to support plunging currency values and tumbling domestic bond prices.
The mass exodus of capital out of the developing world is the most important market trend of 2013 in my opinion. The debt sell-off has now extended to equities – Asian markets were bludgeoned Tuesday – and lending rates throughout the emerging markets are spiking higher, threatening economic growth.
To date, the new destination for repatriated investment assets is not clear. Inflows into U.S. equities have been high, but this hasn't translated into sharply higher stock prices yet. But if current trends remain, it's only a matter of time.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.