Risk of Federal Reserve interest rate hike weighs on market sentiment, bond declines spread to emerging markets

According to Zhihui Finance APP, as concerns about a potential Federal Reserve rate hike this month become the dominant factor shaping market sentiment — overshadowing the impact of Middle East tensions and volatility related to artificial intelligence (AI) — the global bond sell-off has spilled over into emerging markets. From South Africa to South Korea and Poland, 10-year government bond yields have risen.

Among them, South Africa, seen as a bellwether for emerging market assets, led the decline in the major emerging bond markets on Tuesday. Data shows that South Africa's 10-year government bond yield rose by 9 basis points to 8.83%, the highest level since July 24. Yields on similar tenor bonds in South Korea, Indonesia, and Latvia all climbed by 5 basis points.

Meanwhile, JPMorgan data shows that the risk premium on emerging market US dollar bonds increased by 6 basis points on Monday, reaching 235 basis points. Credit default swap (CDS) prices for 30 developing country sovereign issuers have now risen for a fourth consecutive day, marking the longest streak of increases since April.

Currency market data indicates that markets currently estimate the probability of the Federal Reserve raising the benchmark interest rate by 25 basis points on September 16 is close to 70%. This pricing comes after Federal Reserve Chair Kevin Walsh sent a hawkish signal at last week's Jackson Hole central bank symposium. Walsh stated that US inflation has not slowed meaningfully and that the Federal Reserve may need to act.

Since reaching a record high on August 25, emerging market local currency bonds have continued to decline. Concerns over persistently high inflation and the Federal Reserve's hawkish stance have weakened investors' appetite for risk assets. Despite the continued rally in AI stocks and investors' ongoing optimism about carry trade opportunities in developing countries, emerging market local currency bonds are still falling. However, some asset managers say that as global investors push for more diversified portfolios away from US dollar-denominated assets, capital inflows will likely return soon, providing support for bond prices.

Pessimism has also spread to foreign exchange markets, with most emerging market currencies declining. The Indian rupee and New Taiwan dollar edged slightly higher, while the South Korean won, Hungarian forint, Malaysian ringgit, and Israeli shekel were among the worst performers.

Simon Quijano-Evans, Senior Emerging Markets Strategist at Macro Hive, wrote in a report: "Emerging market FX remains in relative value mode, digesting Walsh's remarks from last Friday. The market is effectively doing the central bank’s work for them. The question now is whether the market will start to anticipate central banks like the Federal Reserve entering the bond market as buyers again."

Emerging market equities, on the other hand, continued their upward momentum. The MSCI Emerging Markets Equity Benchmark Index rose by 0.3% on Tuesday, after notching its largest monthly gain since 2004 in August. TSMC contributed 66% of the index’s advance. Following NVIDIA’s $3.5 billion investment in MediaTek — its largest direct investment outside the US — investor confidence in AI companies in Taiwan, China has been boosted.

As we enter September, new bond issuance activity will pick up again. Saudi Arabia is marketing benchmark-sized US dollar-denominated Islamic bonds with maturities of five and ten years. Pakistan is also holding investor calls to prepare for the issuance of long-term five- and ten-year bonds. The Bank of Israel faces a tough interest rate decision on Tuesday, with economists split on whether the central bank should cut rates for a third consecutive time or leave them unchanged. Policymakers in Israel will seek to balance moderate inflation and a strong shekel — supported by the lull in direct tensions between Israel and Iran — against the fiscal pressures that may mount ahead of the October elections.