Economics Update (July-December 1996)

Do U.S. Markets Call the
Emerging Market Tune?

For emerging market fixed-income trends, watch the U.S. But for emerging equities, this advice doesn't hold true. David Sutton reports.

f the world economy is actually becoming more integrated, it seems reasonable to suppose that changes in financial market prices—such as those on stocks and bonds—are also becoming more closely linked. In Federal Reserve Bank of Atlanta Working Paper 96-7, "Emerging Debt and Equity Markets: An Exploratory Investigation of Integration Using Daily Data," authors Stephen Smith, Mandeep Chahal, and Michael Rebello took on this question and investigated whether returns on emerging market securities are becoming more integrated with related U.S. securities.

In particular, the paper looked into whether important financial "events" in the United States, represented by changes in Federal Open Market Committee (FOMC) interest rate policies, are associated with significant price changes of debt and equity issued by selected governments in Mexico, South America, eastern Europe, and Africa. Using daily observations between 1992 and 1994, the authors found evidence that returns on foreign bonds—particularly Brady bonds (typically collateralized by U.S. government securities)—were significantly influenced by changes in the Fed's federal funds target. And, the report noted, the price linkages were stronger in the latter half of the sample, indicating increasing integration.

Conversely, the authors found almost no evidence to suggest that these developing equity markets respond to monetary policy changes—quite the reverse of the U.S. equity markets, which often respond strongly to rate moves by the Fed.

The report also found that daily price movements of securities—particularly bond prices—in these emerging markets can be predicted by past price fluctuations of U.S. securities. The authors assert that changes in U.S. bond and stock returns can predict future emerging market bond returns. Perhaps most importantly, the evidence showed that this predictability is increasing over time. However, the report noted that emerging-market stock returns are mostly insensitive to price changes on U.S. securities.

The authors also noted that the report's predictability regressions provided additional evidence that emerging and U.S. markets display increasing integration over time. The authors observed a similar integration pattern when comparing Brady bonds with other emerging market debt instruments. In addition, the report indicated that non-Brady debt instruments displayed greater sensitivity to domestic conditions. This reaction is not surprising, given that Brady bonds are collateralized by U.S. government securities while non-Brady debt in the report's sample was not.

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