RISING U.S. TREASURY YIELDS UNDERCUT DEMAND FOR EMERGING MARKET STOCKS, BONDS, AND CURRENCIES -- LOCAL CURRENCY BONDS ARE HARDEST HIT BECAUSE OF WEAKER EMERGING CURRENCIES -- STRONGER DOLLAR FAVORS US OVER FOREIGN STOCKS
EMERGING MARKET STOCKS FALL HARD DURING MAY... The main story of the past week has been the upside breakout in U.S. Treasury bond yields to the highest level in thirteen months, and the corresponding drop in bond prices. The jump in bond yields during the month of May contributed to heavy selling of dividend paying stocks -- mainly telecom, utilities, and REITS. The ripple effects of the jump in U.S. bond yields extends to foreign markets as well-- emerging markets in particular. Chart 1 shows Emerging Market iShares (EEM) dropping sharply during May (-3.8%). The biggest emerging market losers during 2013 have been countries tied to commodities. Since the start of 2013, Brazil and Russia (which export commodities) lost -9% and -15% respectively. China (the world's biggest importer of commodities) lost -10%. [The EEM has lost -7% during 2013, while EAFE iShares (developed markets) and the S&P 500 rose 5% and 15% respectively]. During those five months, commodity prices fell -4% while the U.S. Dollar Index gained 4%. The rising dollar has been a side-effect of expectations for higher U.S. rates. While the rest of the world is still easing (or just starting to), expectations are building that the U.S. is tapering its quantitative easing program. The stronger dollar has also had a direct negative effect on emerging market currencies, and an indirect negative impact on emerging market bonds.
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Chart 1
EMERGING MARKET CURRENCIES ALSO TUMBLE... Chart 2 shows the WisdomTree Emerging Currency ETF (CEW) plunging during May to the lowest level in nine months. The CEW reflects the lower trend of a basket of eleven emerging market currencies. It's not a coincidence that the CEW plunge took place during May. That's when U.S. Treasury bond yields starting rising. Chart 2 shows the May tumble in the CEW (red line) coinciding exactly with the sharp upturn in the 10-Year T-Note Yield (below chart). The drop in emerging currencies is a side-effect of a rising U.S. dollar. But it also reflects a move out of emerging market assets, which include bonds. When global investors sell emerging market stocks and bonds, they also indirectly sell the local currencies.
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Chart 2
EMERGING MARKET BONDS PLUNGE ... One of the side-effects of the Fed's quantitative easing has been to drive global funds into higher yielding assets around the world. That of course includes stocks (especially dividend payers). But it also includes emerging market bonds that pay higher yields than U.S. Treasuries. That has changed over the last month. Chart 3 shows two emerging market bond funds tumbling during the month of May to the lowest levels in nine months. The green line plots Emerging Market Bond iShares (EMB), while the red line tracks Emerging Markets Local Currency Bond iShares (LEMB). Although both fell heavily, the local currency fund fell -6.2% during May, versus a loss of -5.0% for the Bond iShares. The reason for the smaller loss in the latter is that the EMB is denominated in U.S. dollars, while the weaker LEMB is denominated in local emerging market currencies. A bet on the LEMB is also a bet on the direction of local currencies. When local currencies are falling (as they are now), the local currency bond fund will do worse than the one denominated in a stronger U.S. Dollar. The bottom line, however, is that global investors are abandoning emerging market debt. The reason for that is the same reason why they're abandoning dividend-paying stocks. With the prospect for higher bond yields in the U.S. (and a stronger dollar), the demand for higher-yielding foreign alternatives has been greatly diminished.
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Chart 3
RISING DOLLAR HELPS US STOCKS... One of the side-effects of a stronger dollar is that it favors U.S. over foreign stocks. The blue line in Chart 4 is a ratio of the S&P 500 divided by the Vanguard All-World ex-US ETF (VEU). [The VEU is a basket of foreign developed and emerging markets]. The green matter represents the trend in the U.S. Dollar Index. Generally speaking, U.S. stocks do better than foreign stocks when the dollar is stronger -- which has been the case since the second half of 2011, and the first five months of 2013. But there's a downside to that as well. While U.S. stocks are doing better than foreign stocks, they're not immune to setbacks in foreign stocks. Which bring us to Chart 5, which shows the Vanguard All-World ex-US ETF pulling back from chart resistance formed during spring 2011 (red circles). This week's selling in foreign emerging and developed markets (especially Japan) could cause some short-term profit-taking in the U.S. That may have contributed to Friday's late selling in U.S. stocks.
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Chart 4
