Frontier countries to suffer most if Fed rate gets to 6%

Emerging markets are facing their demons as traders mull whether US Federal Reserve interest rates will rise as high as 6%, a level that could kick weaker countries when they're down, while diverging global growth paths and China's reopening might cushion some of the blow for the bigger ones.

Expectations for where the Fed's terminal rate would peak have been rising at breakneck speed: Markets are pricing in a 5.5%-5.75% range for September, while the CME FedWatch toolshows a near 50% chance for the band to hit 6% that month.

The scale and pace of the move makes for uncomfortable reading for investors in developing stocks, bonds and currencies that have often buckled under rising global rates.

"The current repricing risk in the Fed's terminal fed funds rate to perhaps 6% in a short period of time is in the context of (the) response to inflation running stubbornly well-above target in a weakening global GDP growth environment," Satyam Panday, chief emerging markets economist at S&P Global Ratings told Reuters.

"This mix is generally a net negative for emerging markets."

Expectations for further Fed hikes had been for 25 basis point increments, but Fed Chair Jerome Powell on Tuesday brought a faster pace back to the table. Few expect a smooth ride for the remainder of the week, with the monthly US jobs report for February providing markets with more evidence to chew over.

"Fed tightening towards 6% would firmly test historical 'pain thresholds' for emerging market assets," said UBS strategist Manik Narain in a note, predicting India's rupee, China's yuan and the Philippine and Chilean pesos could weaken as much as 5% if the Fed ramped up rates to 6%.

A recent Barclays analysis showed a 50 basis point Fed rate hike would increase interest rate volatility, which "would be more destabilizing initially, as it typically comes with EM FX underperformance, which could trigger a further leg up in EM rates."

Analysts at JPMorgan expect the dollar to weaken once the terminal rate stabilizes, but a 50-basis point Fed hike "would be a regime-shift in favor of outsized USD-strength."

Frontier Pain

"Frontier markets is where you'll likely see the brunt of the hit" of sharply rising rates, said Sahil Mahtani, multi-asset strategist at investment firm Ninety One.

The number of smaller, riskier emerging markets where investors demand a premium of 10 percentage points or more over safe-haven US Treasuries has remained broadly steady at around 30 countries, with a recent rally bringing no relief, analysts at Tellimer found. These countries, which include Kenya, Egypt and Pakistan, are essentially locked out of capital markets.

But local fixed-income markets in bigger developing economies are also set to feel the pinch. A 6% Fed rate environment alongside still-hot inflation does make short-term rates in Chile and India as well as Poland, the Czech Republic and Hungary most vulnerable, UBS found.

Flows to EMs soared in January but slowed to a crawl in February, signaling a warning to investors. Citi data showed on Monday that outflows resumed last week, with real money leaving Latin America and emerging Europe, the Middle East and Africa while hot money, or speculative capital, left Asia and Latam.

Investors, especially on the equities side, could see China's reopening somewhat offsetting a looming downturn in the United States and some of Fed rates' historic weight on emerging markets.

Emerging stocks (.MSCIEF) are up just 2% this year after a combined 26% drop in the previous two and broadly lag developed peers. Chinese equities could provide a safe haven in a 6% fed funds rate scenario, UBS said.

The emerging market universe being more Asia-centric than in previous sharp increases of global rates means that investors can't "look at the textbook of history" according to Nuno Fernandes, a New York-based portfolio manager for GW&K's Emerging Wealth Equity Strategy.

China accounts for nearly a third in the EM equity benchmark (.MSCIEF) and near 5% in the fixed-income hard-currency index (.JPMEGD), which is supportive of the asset class.

"Investors are conditioned to think that EM tail risk emerges in the context of aggressive US rate hiking cycles," said Ninety One's Mahtani. "I think it's dangerous to say this time is different, but it feels like it's not that mechanical this time."