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scott barlow

Global investors are fleeing emerging-market bond funds and this is bad news for the loonie and domestic equity markets.

Bloomberg data show that the world's largest emerging market bond ETF, iShares J.P. Morgan USD Emerging Markets Bond ETF, saw the largest daily outflows in its history on Friday. The ETF had seen high levels of inflows throughout 2016 as developed world investors desperate for yield piled in. The increasing likelihood of a U.S. Federal Reserve rate increase – one that would push U.S. interest rates and bond yields higher, attracting investor assets back into U.S. Treasuries – has put this trend into reverse in recent days.

The first chart below highlights why this market pattern matters to Canadians. The value of the Canadian dollar has been tracking with the MSCI emerging markets currency index in the past four years. The sales of emerging-market bonds put downward pressure on emerging-market currencies and the risk is that the loonie will fall to match.

The recent sell-off in developing world bonds and currencies was significant, but not yet enough to reverse the positive trend for the year. Merrill Lynch strategist Ajay Kapur, however, expects further weakness in the near term. Mr. Kapur points to investor positioning (global manager overweights and underweights), technical analysis and put/call ratios, as signs that sentiment in emerging markets had become euphoric, paving the way for asset price declines.

The second chart underscores why Canadian equity investors should take market weakness in emerging markets seriously. Once adjusted for currency, the S&P/TSX composite has closely tracked the MSCI emerging markets index of developing world equities.

Rising global bond yields, reflecting fears of an imminent Federal Reserve rate increase, have been the main catalyst for recent market volatility. It is likely that the future course of these charts will be determined primarily by the Fed.

If the U.S. central bank finally follows through on a rate hike, emerging markets, and by extension Canadian equities, are likely to fall. It's difficult to overstate the negative effects of higher Treasury yields on emerging market investment inflows. In 2014, the head of Brazil's central bank compared U.S. bond markets to a "vacuum cleaner" sucking money out of his country.

The Federal Reserve could once again delay raising rates, which would help keep the U.S. dollar weak and allow emerging markets assets and the S&P/TSX composite to continue to strengthen.