Crisis-weary emerging-market traders have yet another hurdle in store. A clear signal from European Central Bank President Mario Draghi tomorrow that he’ll start dialling down a bond-buying programme would be a bigger risk for some developing nations than the Federal Reserve’s widely anticipated rate hike the day before, investors say. 
The threat comes earlier than anticipated and potentially spells the end of the easy-money days that drove flows into emerging markets after the financial crisis, patching over their current-account deficits.
“This is a wake-up call for emerging-market bulls,” said New York-based Jens Nordvig, the founder of Exante Data and Wall Street’s top-ranked currency strategist from 2010 to 2015. “European flows to emerging markets have been incredibly important. Emerging markets are very vulnerable to a shift in the global environment.”
The ECB meeting is the latest in a growing list of risks that includes a hawkish Fed, an increasingly acrimonious fight over global trade tariffs and tinderbox geopolitics on the Korean peninsula. Those factors have already taken their toll: equities in developing nations are set for their worst quarter since 2016 and local-currency emerging-market debt has handed investors a loss of more than 6% in the period.
“The Fed meeting is already priced in,” said Robin Johnson, the head of investments at Nedgroup Investments in Johannesburg. “If there’s a strong statement from the ECB that they will start reducing their buying program, then I think that would have a bigger effect on risk assets.”
Euro-denominated debt has gained in popularity with emerging-market issuers since Draghi started his expanded bond-buying program in March 2015. The lower cost of borrowing in euros due to the ECB’s policy has allowed developing nations such as Egypt, Senegal and Ivory Coast to come to the market with euro offerings for the first time.
Still, issuance in dollars dwarfs the volume of bonds sold in the European common currency. And while the next Fed hike may be priced in, US borrowing costs will ultimately have the biggest impact on emerging-market currencies, creating a “real headwind” for the asset class, according to Erik Nelson, a currency strategist at Wells Fargo in New York.
At least in the short term, Draghi’s plans to end ECB bond buying could even spur gains for developing-nation debt. A decline in the US currency would remove the main source of weakness for emerging-market bonds over the past two months, according to Stuart Ritson, the Singapore-based head of Asian rates and foreign exchange at Aviva Investors.
Most exposed in the longer term are the central and eastern European nations whose economies are fused with the eurozone’s members, said Lars Christensen, Copenhagen-based founder and chief executive officer of Markets and Money Advisory. Next in line: the countries with deep current-account deficits like Turkey and Argentina which rely on foreign financing to close the gap.
Emerging-market currencies weakened 0.2% against the dollar as in London yesterday, falling for the third time in the past four days.
A substantial increase in the risk premium on Hungarian debt is “only a matter of time,” said Christensen, who was among the first to warn of Iceland’s economic meltdown in 2008 when he was chief emerging-market analyst at Danske Bank. The yield on the government’s 10-year government debt was up 19 basis points at one point on Friday at 3.22%, reversing the week’s decline and widening the spread over German bunds.
“We see too-easy monetary policy potentially creating inflationary pressures down the road” in Hungary, said Christensen. “Obviously there will be spillover to all the central and eastern European countries from the ECB tightening.”