Emerging-Market Rally Tempered by Not-So-Dovish Fed Rate Cut

(Bloomberg) -- Emerging-market assets slid Wednesday after the Federal Reserve said today's rate cut was not the start of a long easing cycle.

Money managers and analysts said the Fed decision is slightly negative for developing-nation assets as traders may ease bets on further rate reductions in the U.S. Policy makers cut the upper bound of the Fed funds target rate to 2.25%, as expected.

“When you think about rate-cutting cycles, they go on for a long time,” Fed Chairman Jerome Powell said. “We don't see that. You would do that if you saw real economic weakness and needed to cut a lot.”

Major emerging-market currencies such as the Brazilian real and the South African rand flipped after Powell's comments and stocks extended losses. The fact that the decision had two dissidents also indicated that further reductions will face resistance within the Fed.

“EM investors are caught in a bind,” said Ilya Gofshteyn, a senior emerging-market strategist at Standard Chartered in New York. “Powell sounds less intent on easing monetary policy than markets had come to expect. This isn't a Fed willing to commit itself to substantial further easing.”

Policy makers said they will stop shrinking the Fed's balance sheet effective Aug. 1, ending a process that very modestly tightens monetary policy and was previously scheduled to come to a close at the end of September. That was considered a positive.

The Fed's decision “anchors the risk rally,” said Alejandro Cuadrado, a senior strategist at BBVA in New York. At the same time, “the early quantitative tightening end is a moderate boost.”

Expectations of a Fed rate cut, coupled with prospects of easing by the European Central Bank in September, have boosted developing-nation assets. The average yield on local-currency emerging-market debt fell to an all-time low on July 22 as investors sought higher returns with trillions of dollars of negative-yielding debt worldwide.

Here is what analysts and investors are saying:

Brendan McKenna, a currency strategist at Wells Fargo in New York

• “I expect it to be moderately negative for EMFX,” he said
• “I actually took the FOMC statement as pretty balanced, but Powell's commentary is much more hawkish than the statement”
• Markets are already easing bets on additional rate cuts, which is consistent with a hawkish statement, he said

Christian Lawrence, a strategist at Rabobank in New York:

• “This is negative for emerging markets given it's not as dovish as expected”
• “I didn't expect them to bring forward the end of QT to tomorrow, so I think this is dovish. But of course, Powell is being very cautious”
• “We thought too much was priced in for this year, and the market is moving in that direction”
• “57 basis points is priced in now, which is reasonable. When it was 70 basis points I thought it was too much.”

Win Thin, the New York-based head of currency strategy at Brown Brothers Harriman & Co.

• “EM FX was looking for a very dovish Fed I think and we didn't get it,” he said

• The Fed does not seem to be in a hurry to cut again

• Powell “sounds quite upbeat and is playing up the ‘insurance' nature of this cut”

Sacha Tihanyi, deputy head of emerging market strategy at TD Securities in New York

• “He's really not committing to further cuts,” strategist said

• “The tone of the statement didn't sound dovish enough for what the market is pricing going forward, so that needs to be corrected”

• “If the 10-year U.S. Treasury security starts to come off (and yields surge) that will be much more difficult for EM to handle”
• “The fundamental picture in EM is negative currently, and the only real support is coming from volatility suppression on the part of the Fed”

To contact the reporters on this story: Aline Oyamada in Sao Paulo at aoyamada3@bloomberg.net;Sydney Maki in New York at smaki8@bloomberg.net;Justin Villamil in Mexico City at jvillamil18@bloomberg.net

To contact the editors responsible for this story: Julia Leite at jleite3@bloomberg.net, Philip Sanders

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