The Fed – U.S. Interest Rates and Emerging Market Currencies: Taking Stock 10 Years After the Taper Tantrum

In general, higher U.S. Treasury yields boost the exchange value of the dollar against EME currencies but changes in risk premiums and other factors can also play an important role. To analyze the role of risk premiums, we consider two broad types of shocks identified based on the comovement of the 10-year U.S. Treasury yield with the VIX index and a measure of U.S. high-yield corporate spreads. Monetary shocks lead to positive comovement; for example, higher interest rates driven by inflationary pressures or perceptions of a more aggressive Federal Reserve reaction function weigh on the growth outlook and reduce risk-taking in financial markets. In contrast, growth/risk shocks drive negative comovement; higher values of the VIX index/high-yield spread are associated with lower U.S. Treasury yields when negative growth/risk shocks drive financial markets as investors prefer safer assets and expect monetary easing in response to lower growth (or increased downside risks to growth), and vice versa. In the case of monetary shocks driving U.S. yields higher, both the interest-rate and risk premium channels work in the direction of EME currency weakness. In contrast, the two channels work in opposite directions in case of growth/risk shocks. For example, a negative growth shock could cause dollar appreciation against EME currencies even as U.S. yields fall because the premiums that investors require to hold risky assets generally rise, and this effect could more than offset the downward pressures on the dollar due to the lower U.S. yields. Similarly, if a positive growth/risk shock drives U.S. yields higher, the effects on EME currencies may be dampened by compressing risk premiums. In table 1, we summarize the types of shocks and their predicted effects on the dollar against EME currencies.

Table 1: Different Economic Shocks, U.S. Yields, and U.S. Dollar against EME Currencies

Table 2: Changes in Key Indicators during the EME Currency Depreciation Episodes

In contrast to these episodes, investor expectations for expansionary fiscal policy following the U.S. elections in 2016 drove the 10-year U.S. Treasury yield higher and VIX index/high-yield spreads lower, representing a positive growth/risk shock. Dollar appreciation in this episode is consistent with the interest-rate channel dominating. Interestingly, the average EME currency depreciated less than the average AE currency against the dollar, which is the opposite of what we observe for the previously discussed negative growth/risk events, once again highlighting the importance of the risk premium channel for EME currencies.

To develop a deeper understanding of the role of different drivers of EME exchange rates and distinct aspects of the taper tantrum, we next conduct a cross sectional analysis. We evaluate several potential drivers, all measured prior to the events under consideration so they can be considered as predetermined characteristics that can explain responses to different types of shocks. First, we consider exposures of EME currencies to common risk factors, including U.S. Treasury yields, by estimating the following time-series regressions for each episode:

$$$$ \Delta y_{it} = \alpha_i +\beta_{i1}\Delta VIX_t + \beta_{i2}\Delta HYS_t + \beta_{i3} \Delta UST_t + \epsilon_{it}, \text{for}\ i = 1 , \cdots , \text{N}, $$$$

where $$ N $$ denotes the number of currencies, $$ y_{i} $$ is the natural logarithm of the bilateral exchange rate measured as EME currency per dollar, HYS indicates high-yield corporate spreads, and UST indicates the 10-year U.S. Treasury yield. We use five years of weekly data prior to the onset of each episode to estimate these regressions for each currency. On average, all three betas are positive indicating that reduced risk appetite (reflected in increases in VIX and HYS) is associated with EME currency weakness and, after controlling for risk appetite, higher U.S. yields boost the dollar as we conjectured above. The cross-sectional analysis involves calculating the correlations between depreciation of EME currencies during the episode with the estimated betas, i.e. we calculate $$ Corr ( \Delta \tilde{y}_i , \hat{\beta}_{ij} ) $$ for $$j$$=1,2,3 and $$i$$, where $$ \Delta \tilde{y}_i $$ denotes the depreciation of the $$i$$^th currency during the episode.

Correlation of depreciation with deviation of REER from its long-run average changes sign across the events and is negative on average. Hence, investors typically demanded higher risk premiums in the face of large shocks to hold currencies of countries with depressed valuations. Only during the European debt crisis and taper tantrum REER deviation has a mild positive correlation with depreciation, suggesting that prior investor optimism may have amplified the moves during these events.

Table 3: EME Currency Characteristics and Depreciation

References

Ahmed, S., Coulibaly, B. and Zlate, A., 2017. International financial spillovers to emerging market economies: How important are economic fundamentals?. Journal of International Money and Finance, 76, pp.133-152.

Farrell, D., Eckerd, G., Zhao, C. and O’Brien, M., 2020. Tracking Spillovers During the Taper Tantrum: Evidence from Institutional Investor Transactions in Emerging Markets. Available at SSRN: https://dx.doi.org/10.2139/ssrn.3640801.

Taper tantrum (05/02/2013 – 09/05/2013)

• At its May meeting, the FOMC introduced language in its policy statement regarding a potential change in the pace of asset purchases. Though initial reaction was muted, the 10-year U.S. Treasury yield rose noticeably in the following days.
• Subsequently, Chairman Ben Bernanke’s remarks at his congressional testimony on May 22 and the press conference following the June FOMC meeting were interpreted as signaling the future tapering of the Federal Reserve’s asset purchases. Although these communications were largely in line with expectations reported in the FRBNY Survey of Primary Dealers, they resulted in sharp increases in the 10-year U.S. Treasury yield.

Commodity price declines / global growth concerns (11/10/2014 – 03/16/2015)

• Booming U.S. oil production and OPEC’s November 2014 decision to not cut oil production drove large decreases in oil prices. The price of Brent crude oil fell about 35 percent to 53 dollars per barrel over the episode.
• Though the drop in oil prices was mostly supply-driven, contemporaneous large declines in industrial metals prices suggest demand also played a role. Indeed, Perez-Segura and Vigfussion (2016) find that while supply-induced changes drove oil prices during the summer and early fall of 2014, lower global demand played an important role in late 2014 and early 2015.
• At the same time, the European Central Bank reduced its policy rate to negative territory and embarked on large scale asset purchases in the face of falling inflation expectations and increased downside risks. The euro depreciated about 25 percent against the dollar from March 2014 to March 2015, with about half of the depreciation occurring during the episode under consideration. Currencies of eastern European EMEs with strong ties to the euro-area economy depreciated notably against the dollar.

Renminbi devaluation / China slowdown (05/20/2015 – 09/23/2015)

U.S. Elections (08/16/2016 – 12/20/2016)

• The U.S. elections led to significant shift in market expectations for increased fiscal stimulus, higher U.S. inflation, and somewhat tighter monetary policy. Two- and 10-year U.S. Treasury yields rose 47 basis points and 99 basis points to 1.22 and 2.56 percent, respectively, while the 5-year inflation swap rate increased about 60 basis points to 2.1 percent.

Trade tensions / Fed tightening (04/11/2018 – 08/15/2018)

• U.S authorities imposed tariffs on Chinese exports in various categories in February and March. Tensions increased further when China announced retaliatory tariffs on U.S. exports in April. Further tariffs were imposed by U.S. in early July and China retaliated again.
• The renminbi depreciated 11 percent against the dollar and Chinese equities declined 15 percent during the episode.
• The trade tensions arose against the backdrop of Federal Reserve monetary policy tightening, with 2-year U.S. Treasury yield rising 30 basis points over the period.

COVID-19 (01/02/2020 – 05/07/2020)

• Public health restrictions, collapsing global economic activity, and strong investor demand for safe liquid assets led to large declines in EME asset prices and capital outflows from EMEs.

Acceleration of monetary tightening in advanced economies (06/08/2022 – 10/12/2022)

• With high and persistent inflation in many countries across the globe, synchronous tightening by major central banks led to concerns about global growth and weighed on risk appetite. Policy rates increased at a historically fast pace: the federal funds rate increased 300 basis points from early June to early November while comparable overnight rates rose 200 basis points in the euro area and the U.K. over the same period.

• Commodity prices declined notably, partially reversing increases following Russia’s invasion of Ukraine and the resulting disruptions in commodity markets.