What the bond rout means for emerging markets

Stocks and currencies are not the only markets caught up in the bond market turmoil this week. Emerging markets have also felt the pain, highlighting their vulnerability to events in the developed world.

MSCI's emerging market stock index was on track Friday for a third straight week of losses, while the Indonesian rupiah hit a 17-year low against the dollar earlier in the day and the Russian ruble hit a two-month low on Thursday.

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This week's sell-off in global bond prices, pushing yields on U.S. Treasury and European government bonds sharply higher on changing perceptions about the inflation outlook, has spilled over into emerging markets.

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And analysts say it's exacerbating the volatility at a time when jitters about the timing of a possible rise in U.S. interest rates and concern about Greece's future in the euro zone have tempered appetite for risky assets.

"Sentiment towards emerging markets has deteriorated significantly on the back of the sell-off in government debt markets, with a sharp increase in outflows from emerging market debt funds this week," Nicholas Spiro, managing director at Spiro Sovereign Strategy, told CNBC.

"Emerging markets are facing a triple whammy of a sovereign bond sell-off, a plethora of country-specific risks (not least Greece) and an anticipated tightening in U.S. monetary policy," he said.

Who's to blame for market volatility?
Who's to blame for market volatility?   

Analysts say that central European countries were especially vulnerable to the sell-off in German Bunds as their markets are closely correlated to price action in the euro zone.

Contagion

There's also the Greece factor, with turmoil there likely to hurt the outlook for the euro zone and the emerging markets with which it has close economic and trade links.

"Clearly Greece is the big unknown at the moment. Contagion from that would probably be concentrated in parts of eastern Europe, which have the closest linkages to the euro zone," Capital Economics Senior Emerging Markets Economist William Jackson told CNBC.

Greece on Friday delayed a loan repayment to the International Monetary Fund and a deputy minister said the government could call a snap election if its creditors do not soften a compromise deal that could unlock much needed aid.

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A Greek bailout program expires at the end of June and if a cash-for-reforms deal is not reached by then, analysts expect then the risk of a default to rise sharply, raising the prospect of the country's exit from the euro zone.

"The real risk is that weaker growth in the euro zone and problems in the banking sector hurt parts of central and Eastern Europe," Jackson said, referring to the impact Greece would have on emerging markets.

These emerging markets look vulnerable
These emerging markets look vulnerable   

Don't forget the Fed

Although markets have scaled back expectations for the timing of a rise in U.S. interest rates from June to later this year, the prospect of monetary tightening in the world's biggest economy remain a key risk for emerging markets, analysts said.

In a note on Friday, Mark Mobius, an emerging markets fund manager at Franklin Templeton Investments, said it seemed likely that the Federal Reserve was in no rush to raise rates.

"Nonetheless, the markets will likely react when the Fed does act, so we are remaining cautious, and planning for some volatility ahead," he wrote.

In fact, until the outlook for U.S. rates becomes clearer, markets generally will be in for greater volatility, said Joe Zidle, portfolio strategist at Richard Bernstein Advisors.

"We'll have volatility until we get stronger-than-expected data that tells people the Fed is going to hike more quickly or weaker data that suggests the Fed will be hold," he told CNBC.

Jackson at Capital Economics said Turkey and South Africa were two emerging markets to watch most closely in terms of further volatility.

Turkish assets have faced additional pressure from uncertainty ahead of a weekend election that could force the ruling AK party to form a coalition. The Turkish lira traded at about 2.66 per dollar on Friday, holding near one-month lows.

"On every single measure of vulnerability you can look at, Turkey usually comes near the top," said Jackson.