The Relationship Between The Dollar And Emerging Markets Bonds: Closer Than Equities? 3

As we saw in the first article of this series, since the late 1990s, emerging market equities have outperformed when the dollar declines. The relationship between the greenback and emerging markets bonds is even more notable.

The graph below plots the movement between the dollar and the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) – the largest ETF investing in emerging markets bonds. It invests in hard-currency bonds.

For the ten year period shown in the graph, the inverse pattern of price movement is strongly visible.

- Advertisement -

The relationship between the greenback and emerging market bonds denominated in local currency further solidifies this assertion.

The graph above plots the movement between the dollar and the VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (EMLC).

Why is this relationship so close?

The reason why the dollar and emerging markets bonds show this seemingly uncanny relationship is of course because of the greenback itself.

In the case of EMB and other instruments investing in dollar-denominated bonds, the movement in the dollar is directly reflected in the underlying bonds. For ETFs investing in local-currency bonds, the case is similar, but in the opposite direction of their dollar-denominated relatives.

This has been the case in 2017 as the weakness of the dollar against several emerging markets currencies has led local currency-denominated bonds and funds to outperform their hard-currency peers.

Since movements of the greenback have a much higher impact on the returns of bond funds, and is sometimes primarily responsible for their movement, the relationship between the dollar and emerging markets bonds is closer than that of the dollar and emerging markets equities.

A more subtle yet profound point to make here is that when investors are investing in emerging markets bonds, regardless of the denomination, they’re essentially placing a bet on the movement in the dollar and emerging markets currencies.

What does this relationship between the dollar and emerging markets bonds and equities mean for the latter? Let’s assess in the next article.

- Advertisement -