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Prep for extended volatility, warn experts 0

Jul 2, 2013

Latin financial markets must dig in for an extended period of volatility as policymakers grapple with the fallout – including on local currencies, prices and interest rates – of rising US Treasury yields, leading experts have warned.

Guillermo Calvo, a former IDB chief economist, said that domestic interest rates could rise sharply as liquidity dries up.

"The whole bonanza period and the prices of bonds in the region are very much due to external factors. Once those factors threaten to change – and we’ve seen this before, in 1994 for example – the markets can get very nervous and this can have a very strong liquidity effect on the region and have an impact on interest rates in particular," he said.

Investors have sharply readjusted allocations away from emerging markets in recent months in anticipation of normalizing US monetary policy, driving long-term US interest rates up and Latin currencies down.

But Calvo, co-author with Carmen Reinhart of a seminal study on the impact of US interest rates on capital flows to Latin America, said authorities in the region could be forced to hike interest rates as they move to defend their currencies.

Brazil faces the most pressing macro challenges, he said. "I see Brazil, for example, being reluctant for its currency to devalue because they feel there’s going to be very quick transmission from devaluation into inflation. The last thing they want now is inflation," he said.

"The moment the market realizes that they are starting to lose reserves – even though they have a bundle of reserves – that could feed into higher interest rates at home. That feeds into the fiscal deficit, which is still a problem for them. So they may get into the vicious cycle in which they were immersed in the 1980s. "

Calvo added that heightened policy uncertainty across the region remained the biggest risk. "The factor that is crucial to the story is: what will governments do if the situation worsens? They haven’t been tried by fire.

"I’m afraid they will start resorting to old-fashioned policies of intervention and capital controls. If the market factors that in, this can become deadly. In that case, no one in their sane mind will buy Latin American bonds because all of a sudden these firms won’t be able to repay because of capital controls."

The impact of higher US Treasury yields – which by Monday had hit 2.5%, 64 basis points higher than at the start of the year – is already being felt in Latin markets. Analysts at Itaú Unibanco have raised their inflation expectations for Mexico this year by 10 basis points to 3.6%, saying the devaluation of Mexico’s currency has been "more intense and longer lasting that we previously thought".

The peso, which had been strengthening all year, reversed the trend sharply in early May. Investors dropped the currency, pushing it down from 11.98 pesos to the dollar on May 8 to 13.31 in late June, although it has since retraced some of the fall, trading at 12.96 pesos to the dollar on Tuesday.

Neil Shearing, chief emerging markets economist at Capital Economics in London said the regions is on a "far more stable footing" than it was in 1994, when a sharp hike in US short -term interest rates devastated Latin economies. "This time around they have less foreign currency debt, so there is less worry about currency weakness."

     
     
     


But the possibility that US interest rates could rise faster than expected remains a source of concern. "What worries me is that if the Fed finds itself in a situation where it has to hike interest rates very quickly, then we could have a problem," said Liliana Rojas-Suarez, senior fellow at the Center for Global Development. "Rates could rise much faster than the market is currently pricing in. The market could force it to happen." LF


Read more:
LatinFinance July Cover Story: The writing on the wall
LatinFinance Daily Brief: EM exodus picks up pace



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