When US government bond yields climb, the effects travel far beyond Wall Street. Some of the biggest moves can show up in emerging market currencies, from the Mexican peso and Brazilian real to the South African rand and Indian rupee. With the US 10-year yield recently at its highest level in more than two decades, it is worth understanding why.
What counts as an emerging market
Emerging markets are economies that are growing and industrialising but are not yet considered fully developed. Their financial markets tend to be smaller and less liquid than those of the US, the eurozone, Japan or the UK. That means money flowing in or out can have a bigger effect on prices, including exchange rates.
The pull of higher US returns
Global investors are always comparing returns. Emerging market bonds often pay higher interest rates than US Treasuries to compensate for extra risk, such as higher inflation, political uncertainty or weaker institutions.
When US yields rise, that extra return shrinks. If an investor can earn a healthy return from US government debt, often seen as one of the safest assets in the world, the case for taking on emerging market risk becomes weaker. Some money flows back to the US, which means selling emerging market assets and their currencies and buying dollars. Our guide to how interest rate expectations move FX explains this pull in more detail.
The carry trade unwinds
A related effect involves the carry trade. Traders borrow in a low-yielding currency and invest in a higher-yielding one, earning the difference. Emerging market currencies are popular targets because of their higher rates. When US yields rise or volatility increases, those trades become less attractive and riskier, and investors may close them quickly, adding to selling pressure. Our explainer on carry trades covers how they work.
The dollar debt problem
Many emerging market governments and companies borrow in US dollars rather than their own currency, because lenders prefer it. When the dollar strengthens, those debts become more expensive to repay in local currency terms. That can strain balance sheets, worry investors and lead to further currency weakness, creating a feedback loop.
Not all emerging markets are equal
The impact varies. Countries with large current account deficits, meaning they rely on foreign money to fund their spending, tend to be the most vulnerable. So are those with low foreign exchange reserves, high inflation or heavy dollar borrowing.
Countries with strong reserves, trade surpluses and credible central banks are usually more resilient. Commodity exporters may be cushioned if the goods they sell are rising in price at the same time. Some central banks respond by raising interest rates or using reserves to support their currencies, though that has costs for growth.
Lessons from history
The 2013 taper tantrum is a well-known example. When the Federal Reserve signalled it would start slowing its bond purchases, US yields jumped and several emerging market currencies fell sharply. Analysts labelled the most exposed economies the “fragile five” because of their reliance on foreign funding.
What it means for traders
For FX traders, rising US yields are a reason to pay closer attention to emerging market currencies, particularly those with known vulnerabilities. Moves can be fast and liquidity can thin out during stress, so spreads may widen and gaps can occur.
The relationship also works in reverse. If US yields fall back, perhaps because of softer data or a shift in Federal Reserve expectations after events such as today’s FOMC minutes, pressure on emerging market currencies can ease. Our guide to the dollar smile theory offers a useful framework for thinking about when the dollar tends to strengthen.
The bottom line
High US yields act like a magnet for global capital, and emerging market currencies often feel that pull most strongly. Understanding which economies are most exposed helps traders make sense of moves that can otherwise seem sudden.
If you want to understand how global rates and currencies fit into your own trading approach, our free trader assessment is a sensible next step and shows what to focus on.
