Emerging-Market Bulls Brace for Treasury Relapse After Rally

Emerging-market bulls who’ve benefited from moderating U.S. Treasury yields are bracing for a relapse as political risks pile up.

MSCI Inc.’s developing-nation stock gauge extended a three-week winning streak on Friday, while a basket of currencies capped its biggest weekly advance since early February. The risk premium on emerging-market sovereign debt narrowed to 339 basis points over U.S. Treasuries, its lowest since February 2020, according to data compiled by JPMorgan Chase & Co. Investors continued to pour money into exchange-traded funds dedicated to emerging markets.

Yet the rally is prompting some traders to reassess their bets. Russian shares, which led last week’s equity advance, may come under pressure as the Biden administration evaluates its options to escalate sanctions. South Africa’s rand, the top currency performer in the developing world, is particularly exposed to a potentially stronger dollar, Andres Jaime, a New York-based strategist at Morgan Stanley, wrote in a note. There’s also concern that Treasury yields, which have declined for two straight weeks, will revert back to their trend in the first quarter, when U.S. bonds suffered their worst rout since 1980.

Goldman Sachs Group Inc. said it closed its trade recommendation on a basket of developing-nation currencies after the rapid rebound.

“Some profit taking on rallies and re-engagement on market wobbles makes sense, even as we keep the faith on cyclical upside over the longer term,” Goldman strategists including Zach Pandl and Kamakshya Trivedi wrote in a note Friday. “The idiosyncratic risks that have weighed on EM FX in 2021 are likely to continue to generate volatility and create opportunities.”

Listen: EM Weekly Podcast: Easing U.S. Yields; Russia, Indonesia Rates

Aside from Russia, political risks are gathering pace in Latin America and Asia. Peruvian stocks dropped to their lowest since January after an admirer of Fidel Castro and Hugo Chavez won the most votes in the first-round of the nation’s presidential election. In China, the credit stress engulfing one of the country’s largest distressed-debt managers is also weighing on shares and bonds.

Investors will turn their attention this week to key rate decisions. Indonesia’s central bank may leave borrowing costs unchanged while their Russian counterparts hike. President Vladimir Putin will also make his annual address to the nation on Wednesday, potentially unveiling new measures to boost the economy through spending. He’s facing condemnation from Western officials over the deteriorating health of jailed opposition leader Alexey Navalny as well as the Kremlin’s hack attacks and actions toward Ukraine. The ruble has posted the third-biggest decline in emerging markets this past month.

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