If U.S. interest rates were to rise more rapidly than expected, weaker emerging market sovereigns will be hit hardest, suggests Fitch Ratings.
In a new report, Fitch says that there are several risks surrounding the Fed’s path to more normal rates. “Monetary policy action and timing depend on the outlook for growth, the labour market and inflation, which is uncertain,” it says, noting, “A tightening cycle after such an extended period of low interest rates and unwinding quantitative easing is unprecedented.”
In a scenario where rates rise higher, faster than expected, Fitch says that weaker emerging markets would be most exposed to this sort of interest rate ‘shock’. The rating agency imagines a scenario where the output gap and labour market slack are eliminated by the end of 2014, causing inflation to rise to 4.5% in 2016; and, in response, the U.S. Federal Reserve Board hikes rates faster than expected, boosting rates to 3% by the end of 2015 and 5% by the end of 2016.
“In the scenario, financial market volatility and risk premiums spike, with spreads over U.S. Treasuries on perceived risky assets such as emerging market bonds widening by 150 [basis points]. U.S. GDP growth drops to 0% in 2016 and unemployment rises,” it says. “Global growth weakens, commodity prices decline, and many emerging markets are forced to hike interest rates. The dollar is volatile, potentially hitting foreign-currency borrowers. Asset prices and collateral values drop sharply.”
In such a scenario, it says that emerging markets with large external financing needs, low foreign reserves, high levels of leverage, vulnerable debt structures, weak policy frameworks, or political fragilities, would be most affected. This includes countries such as Mongolia, Turkey, Ukraine, El Salvador, Hungary, Lebanon and Jamaica.
“Financial markets may also not be fully prepared for higher U.S. interest rates, despite the Fed’s forward guidance. Current low volatility and high asset prices suggest markets have not priced in much uncertainty. Therefore, in our ‘shock’ scenario, the spill-over effects to the rest of the world could be substantial,” said Ed Parker, Fitch’s Head of EMEA Sovereign Ratings.
For the U.S., Fitch says that the sovereign rating could face downward pressure if U.S. authorities don’t move to narrow the budget deficit and to stabilize the public debt/GDP ratio over the medium term.
Of course, this is not the way that Fitch expects events to unfold. “Our base case is for the Fed to gradually tighten monetary policy over the next 12 months, in line with its forward guidance. Raising interest rates and unwinding QE will trigger some increase in financial market volatility, but we do not expect it to fundamentally destabilize global growth or financial markets,” it says.
It expects the Fed to complete the “tapering” of its asset purchase program in October, and to start raising interest rates in mid-2015. Ultimately, it sees rates reaching about 3.75% by late 2017 or early 2018.