Dollar U-turn could call time on 2017's emerging market boom

Developing countries have been on a borrowing binge this year with nine months of bumper investment inflows and record bond sales, but a sharp US dollar bounce into year-end could end the party early.

Signs of an upswing in the dollar's fortunes made the last week of September poor - equities fell 2 percent, bond yields rose about 10 basis points and currencies weakened on average by over 1 percent, their worst week since last November.

While emerging markets are still among the year's best performing assets, the moves last week cast a chill on the sector. They closely emulated those in late-2016 when Donald Trump's US election win and stimulus plans briefly boosted the dollar, ended a three-quarters emerging market rally.

Last week's swings were driven by expectations of a December US rate hike. But possibly, a bigger threat is the revival, after many months, of the so-called Trumpflation bet - Trump's plans for stimulus through tax cuts.

The measures could be immensely dollar-supportive, especially if they induce US firms to repatriate cash held overseas. Estimates of such holdings are reckoned to be well over $1 trillion.

That could see the dollar repeating the 12 percent surge it witnessed in 2005, after a 2004 tax holiday lured home about $300 billion. That's a formidable hurdle for emerging markets, which usually suffer when the dollar strengthens.

“The last time they did it (encouraged dollar repatriation), it had a huge impact on the dollar and this time the scale could be much larger,” Abhishek Kumar, lead portfolio manager for emerging markets at State Street Global Advisors.

On top of that, emerging markets look “frothy in some areas”, Kumar said, citing the fall in corporate dollar bond yields below those on sovereign debt, and successful bond issuance by junk-grade borrowers Tajikistan and Ukraine.

Such frontier market, along with Chinese firms, led a borrowing frenzy that saw bond sales of almost $500 billion in the first nine months of 2017, a quarter above year-ago levels.

Yield-hungry bond investors submitted orders of over $4 billion for Tajikistan's $500 million issue, despite its doubtful economic prospects. A $12.5 billion deal from Saudi Arabia - in recession and struggling with huge budget deficits - enjoyed bids around $40 billion.

But while such entities benefited from Treasury yields - the reference rate for global borrowing costs - bumping along near multi-year lows, Kumar predicts US tax changes to have “material” impact on the US curve.

Higher US yields, crowding out flows to riskier assets, can drive an exodus from emerging markets, especially when long-dated bond yields rise faster than shorter-maturity debt.

A taste of such curve steepening, as these yield moves are known, came last week as the Treasury curve steepened the most since August. That forced up yields on the new Saudi bonds by around 15 basis points.