Fed the catalyst but not the cause of EM woes

At first glance, it would seem that the big sell off in several emerging market currencies is entirely driven by the shift in US debt markets on Fed policy.  As the chart on the left shows, the spike in US treasury yields since May is almost 100% correlated with the depreciation in the Brazilian Real and the Indian Rupee.

While the shift in debt markets appears to have been a catalyst for the very big moves in these currencies, it seems wrong to to attribute this entirely to "QE tapering" which seems to be the singular focus of markets this summer

I would add that the return to growth in the Euro area has also been instrument in this shift.  To be sure, stronger EU growth and a resilient US has shifted the equation in the EM vs. DM debate.

Even more important is the fact that general economic conditions in both India and Brazil have been disappointing for sometime.  Looking at consensus GDP expectations in both countries, growth has generally disappointed in the last few years.  As the chart left shows, growth in India has failed to hit expectations for a number of years.

While the performance in Brazil has not proven to be much better.

When USD risk free rates are slow low, these growth disappointments are perhaps more tolerable, as risk free alternatives are not providing much return.  But as we are seeing, a 100bps move has dramatically altered that equation for many.

Problematic for policy makers in these countries is that while growth has proven to be disappointing, inflation has been relatively high.   The Brazilian Copom has decided to raise rates more recently to stamp out inflation that has been at the top end of their band, with most forecasters expecting inflation to remain sticky a the top end of the bank's tolerance level of 4.5-6.5%.

In India, the situation is much more difficult, with inflation much much higher than is desirable for the last couple of years. Inflation expectations looking entrenched at concerning levels.

Policymakers in both countries have pointed to the impact of QE expectations on financial flows, but the reality is that the mess they are currently is is of their own doing.  A low global interest rate structure has perhaps exacerbated financial market flows and volatility in these markets, but it is poor domestic economic outcomes that are ultimately driving problems.

For investors, its probably important not to get too tied up in current correlations over the economics.  While shorting certain EM currencies on rising treasury yields has worked fantastically so far, so often these trades work until they suddenly don't.  An investment thesis based on the domestic economics of these markets is likely to hold up better in the longer run than trying to second guess market correlations and Fed officials.