Trading EM Rates: The Fed Cycle and What It Means for You

Chapter 6 is where the book gets into the real meat of EM rates trading. And the first thing it tells you might be surprising: before you can trade EM rates, you need to understand US rates. Because the Fed drives everything.

But before we get to the Fed, there’s an important question to answer first. What even counts as an “emerging market” when it comes to rates?

Not All EM Rates Are Created Equal

Here’s something that catches people off guard. In FX, you can’t really tell the difference between how an EM currency and a G10 currency behaves day to day. But rates? Totally different story.

The authors look at what happens to interest rates when risk aversion spikes (measured by VIX going up). In developed markets, rates drop. People run to safety, buy bonds, yields fall. Classic stuff.

In EM, it’s more complicated. Some EM rates behave exactly like developed market rates. When VIX goes up, their rates go down. South Korea, Taiwan, Czech Republic, Israel, Chile, and even China and India fall into this bucket. These countries have enough credibility that markets believe they can run counter-cyclical monetary policy. They can cut rates during a crisis just like the Fed does.

But then there are the countries on the other end. Brazil, Turkey, South Africa, Indonesia, Russia, Colombia. When risk aversion rises, their rates go UP. Why? Because weaker currencies push inflation expectations higher. Credit spreads widen. And markets start pricing in emergency rate hikes to defend the currency, especially when there’s a lot of dollar-denominated debt floating around.

The authors find a neat threshold: if a country’s five-year CDS spread is above about 100 basis points, its local rates are highly correlated with credit risk. Below that level, the correlation drops fast and rates start behaving more like a developed market product. So really, only a handful of mostly rich EM trade like G3 rates. Most EM rates still have a credit component baked in.

Forget the Structural Trade. Trade the Cycle.

There’s been a persistent fantasy in EM investing: that EM rates would structurally converge toward DM levels over time. Buy and hold, collect carry, watch spreads compress. Easy money.

The data says otherwise. The spread between EM 10-year rates and G3 rates has bounced around between 250 and 600 basis points with no clear downward trend. Maybe the highs during stress episodes are getting a bit lower each time. But the lows during good times aren’t getting lower either. There’s no structural compression trade happening.

And even if there were, the numbers make it brutal to ignore the cycle. The average peak-to-trough move in EM rates over a business cycle is more than 135 basis points. The average structural decline? About 7 basis points per year. So you’d be sitting through massive cyclical swings to capture a tiny structural drift. That’s a bad trade.

The conclusion is clear: trade the cycle. And the cycle starts with the Fed.

The Taylor Rule: Your Starting Point

The Fed follows some version of a Taylor Rule. It’s not perfect, but it’s a solid framework. The rule basically says: set rates based on where inflation and the output gap are relative to target.

The authors show, using work from former Fed chair Bernanke, that the Taylor Rule explained Fed policy pretty well from the early 1990s until rates hit zero in 2008. Especially when you use core PCE instead of CPI and give a bit more weight to the output gap.

Why does this matter for traders? Because if you can forecast where inflation and the output gap are heading, you can forecast where the Fed is going. And if you can forecast the Fed, you’re halfway to forecasting EM rates.

Of course, forecasting inflation and growth is easier said than done. But at least the Taylor Rule gives you a framework to translate your macro views into rate trades. Without it, you’re just guessing.

When the Maestro Rings the Bell

The book has a great story about Alan Greenspan in early 1996. The Fed had been cutting rates through late 1995 and into early 1996. Two-year rates were below Fed funds, meaning the market was expecting more cuts. Then on February 20, 1996, Greenspan gave his testimony to Congress and basically said the economy looks fine and any weakness is probably temporary.

Ten-year swaps sold off 17 basis points that day. And then kept selling off for five more months, peaking at 7.44% in July. Greenspan’s speech marked the absolute low for bond yields that cycle. The next Fed move was a hike in March 1997.

The lesson: central bank speeches can be major turning points. The market can’t fully adjust to a complete change in information in a single day. And in EM, where central banks communicate less frequently than the Fed, these speech-driven moves can be even bigger.

The Simple Trading Signal That Works

Here’s one of the most practical rules in the whole chapter. Watch one-year US swaps relative to the Fed Funds rate.

When one-year swaps fall below Fed Funds from above: receive (go long bonds). The rate cycle is turning, and cuts are coming.

When one-year swaps rise above Fed Funds from below: pay (go short bonds). Hikes are on the way.

The authors show this caught the easing cycles in 1998, 2001, and (after a couple of false starts) 2008. The May 2019 signal also worked well. On the paying side, it’s a bit less clean because positive risk premium in the curve works against payers. But modified to wait until the last cut is clearly behind you, it worked reasonably well in 2003 and 2008.

The beauty of this signal is that by construction, you don’t take on much negative carry at entry. And it keeps you on the right side of the market. You’d need very strong convictions about the economic outlook to go against it.

Patience Pays: Ride the Whole Cycle

Here’s where many traders mess up. They try to be too clever.

A trader might think: “The market is pricing four hikes, but I only think three are coming. So let me receive now and be smart.” The problem is, markets keep pricing more hikes as the tightening continues. Rates keep going higher. Only when the cycle looks like it’s ending do rates start falling.

The data shows something beautifully simple. Stay received (long bonds) from around the last hike until the last cut is close. Stay paying (short bonds) from around the last cut until the last hike is close.

Since 1987, the average Fed hiking cycle lasted 14 months. The average easing cycle lasted just under 19 months. These are long cycles. And they’re long because central bankers are risk-averse. They move in small increments. They’re afraid of being wrong. They suffer from confirmation bias at turning points. A committee that just hiked because they believe the economy is strong isn’t going to suddenly reverse course at the first sign of weakness.

This creates a systematic opportunity. Markets don’t fully price in the extent of a cutting or hiking cycle because forecasting accuracy degrades quickly over longer time horizons. If you correctly identify where the cycle is heading, you can make money either because the market is wrong (not pricing enough cuts) or by earning the risk premium over time.

The receiving side of this trade is more profitable than the paying side. Three reasons: easing cycles are typically bigger and longer than hiking cycles, the period studied was generally a bond bull market, and there’s a structural positive risk premium that subsidizes receivers. This risk premium is even larger in EM, where emergency rate hikes are a much bigger risk than emergency rate cuts.

Curve Trades: Steepeners and Flatteners

The yield curve also follows the Fed cycle in predictable ways.

Steepeners (long 2s/10s) work well heading into the first Fed cut. This makes intuitive sense. The front end drops as cuts get priced in, while the back end moves less. The authors call steepeners “receivers for chickens” because you get a similar directional bet but with a potentially better Sharpe ratio, especially in EM where rising risk aversion tends to steepen curves. Less negative carry also makes steepeners easier to hold.

Flatteners (short 2s/10s) work well heading into the first rate hike. It’s a pleasingly symmetric result. Flatteners are “payers for chickens.” But just like outright payers underperform outright receivers, flatteners don’t work quite as well as steepeners.

There’s an interesting wrinkle at the very front of the curve. The 1s/2s segment behaves differently from the rest:

• 1s/2s flatten after the last hike. Because the average time between the last hike and the first cut is about 10 months (ranging from 3 to 18 months), one-year receivers don’t benefit much by the time cuts actually arrive. There’s not enough DV01 left.
• 1s/2s steepen after the last cut. Same logic in reverse. It takes too long for the first hike to arrive for one-year instruments to benefit.

For cash-constrained investors, even though curves steepen in easing cycles, the long end still outperforms the short end for the same dollar investment. Duration wins. So despite the expected steepening, it’s better to add duration at the long end.

One more stat that grounds this in reality: during traditional monetary policy periods (1990 to 2009), bull steepening happened 27% of the time and bear flattening 22% of the time. Bull flattening was 21% and bear steepening just 15%. So the “normal” patterns (bull steepening in easing, bear flattening in tightening) do happen more often, but not overwhelmingly so. Markets are messy.

QE Changed the Game (Temporarily)

When rates hit zero, the old playbook stopped working for G3. Central banks switched to quantitative easing, and the trading rules changed.

The pattern for QE was: buy Treasuries while QE is being discussed, then sell when it’s actually announced or implemented. Why? Because once QE started, markets began to believe it might actually cause inflation, which is bad for bonds. So rates would rally into QE announcements and sell off after.

But each successive round of QE had less impact. QE1 was huge for markets. QE2 was decent. QE3 barely moved the needle on rates. The strategy of front-running central bank asset purchases got less profitable over time.

The unwinding of QE works in reverse. Rates rise as markets anticipate stimulus removal, then rally when the removal actually hurts risk assets and the economy.

For EM, the QE era had an important side effect. The best short-term rates trades for macro hedge funds were at the front end of the curve, where prices are anchored by central bank policy. With G3 front ends stuck at zero, those trades disappeared. The authors suggest this is one reason macro hedge fund performance deteriorated after 2008. And it’s another reason to look for rates alpha in EM, where the zero bound doesn’t typically apply.

EM Central Banks Can Cut During Fed Hikes (Sometimes)

Here’s a question that comes up a lot: can EM central banks ease while the Fed is hiking? The short answer is yes, but only when the Fed’s hiking cycle is relatively gentle.

The constraint is mostly indirect, working through currencies. If Fed hikes cause EMFX to weaken, inflation rises in EM, and EM central banks can’t cut. But during benign hiking cycles where the dollar isn’t ripping higher, there’s room.

The book shows examples across three Fed hiking cycles: 1999-2000, 2004-2006, and 2015-2018. In each cycle, some EM central banks managed to cut. South Africa and Israel during the 1999-2000 cycle. South Korea and Poland during 2004-2006. India and others during 2015-2018. The fact that more EM central banks were able to cut during the most recent cycle is probably a sign that some EM countries are getting closer to developed market status when it comes to monetary policy.

But the authors are careful to note: the 2015-2018 Fed hiking cycle was unusually slow. If inflation had forced the Fed into a more aggressive tightening, EMFX weakness would likely have been much worse, and the luxury of cutting would have disappeared for most EM central banks.

The Bottom Line

The first half of Chapter 6 lays out a framework that’s surprisingly actionable. Here’s the cheat sheet:

1. Know what you’re trading. Only a few EM behave like developed market rates. Most have a credit component. Check VIX correlations and CDS levels.
2. Forget structural convergence. Trade the business cycle instead.
3. Start with the Taylor Rule for both the Fed and EM central banks. It’s not perfect, but it’s the right framework.
4. Watch the one-year swap vs. Fed Funds crossover. It’s a simple, effective signal for turning points.
5. Be patient. Ride easing cycles until the last cut. Ride hiking cycles until the last hike. Don’t try to be too clever.
6. Use curve trades as a chicken version of directional bets. Steepeners into cuts, flatteners into hikes.
7. In QE environments, buy into the announcement and sell the implementation.
8. EM central banks can diverge from the Fed, but only when the hiking cycle is gentle enough that EMFX isn’t blowing up.

In Part 2, we’ll look at how inflation, FX pass-through, and commodity prices add extra layers of complexity to EM rates trading.

Book Details:

• Title: Trading Fixed Income and FX in Emerging Markets
• Authors: Dirk Willer, Ram Bala Chandran, Kenneth Lam
• Publisher: Wiley
• Year: 2020
• ISBN: 978-1-119-59905-0

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