This week financial market participants were delivered a cogent explanation for the weakness in EM stocks, bonds and currencies by India’s central bank governor, Mr. Urjit Patel. In Mr. Patel’s opinion, the US Federal Reserve’s tightening of monetary policy (most specifically balance sheet shrinkage, or the allowance by the Fed to let maturing bonds roll off their balance sheet without reinvesting the proceeds) combined with more than necessary US Treasury issuance of bonds is to blame for a dollar shortage that is ripping through emerging markets. He points to the widening of US dollar denominated emerging market sovereign bond spreads – the difference between EM debt yields and the 10-year US Treasury yield – as a symptom of the double whammy of policy tightening.

This assertion certainly makes intuitive sense. The Fed’s policy of allowing its balance sheet to shrink necessarily causes other players to enter the market to buy up new issuance of bonds. At the same time, the US Treasury issuing more debt that it needs exacerbates the issue (i.e. it pulls liquidity from the market in order to meet the supply of bonds). This recent experience simply highlights the fact that the Fed is no longer the marginal buyer of government and/or mortgage bonds, and so the US dollar liquidity needed to facilitate debt issuance in the US is being sourced at the expense of EM bonds. But, there may be more than meets the eye when it comes to the underlying roots of EM market struggles.

We can actually test the hypothesis that Fed balance sheet runoff or excess Treasury issuance of securities is to blame for EM market volatility. For example, in the first chart below we plot the EM US dollar denominated sovereign bond spreads to the US 10-year Treasury yield (blue line, left axis) and then overlay the three month difference in Fed assets (red line, right axis, inverted). It’s hard to deny a tenuous relationship, but it leaves a lot of explaining to do.

In the second chart we plot the US term premium (blue line, left axis) – the excess yield investors require to hold longer dated Treasury bonds – and then overlay EM sovereign spreads (red line, right axis). If the Fed growing its balance sheet resulted in an unnatural compression of the term premium, then the Fed shrinking its balance sheet should cause the term premium to normalize and widen out. Therefore, if there is a relationship between Fed’s balance sheet and EM sovereign spreads, there should be a relationship between the US term premium and EM sovereign spreads. As the chart below shows, if there is a relationship it is again only a tenuous one.