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Ding ding: Taper tantrum round two?

Wednesday, 18 Dec 2013 | 9:47 PM ET
Emerging markets react to taper
Wednesday, 18 Dec 2013 | 7:06 PM ET
Emerging markets are in focus after the Fed's taper decision. CNBC's Adam Bakhtiar reports on the reaction during Asian trade on Thursday.

Following the Federal Reserve's highly-anticipated decision to scale back its extraordinary monetary stimulus, should investors brace for another exodus of funds out of emerging markets?

According to strategists, while emerging markets are unlikely to suffer a repeat of the huge outflows seen earlier this year, given policymakers have acted to address economic imbalances, countries running big current account deficits such as India and Indonesia remain vulnerable.

"In our view, there is still a risk that I wouldn't take off the table. We expect the impact to the smaller and more targeted with much more focus on countries running substantial current account deficits," Manpreet Gill, head of fixed income currencies and commodities (FICC) investment strategy, Standard Chartered Bank told CNBC.

(Read more: Is this the 'lion in the grass' for the Fed?)

"Today's market action will be a good indicator of the extent to which markets may worry. We'll be watching currencies like the Turkish lira and Indonesian rupiah," he added.

Tai Hui, chief market strategist Asia at J.P. Morgan Funds, shared a similar view, noting, "I don't think the outflow is going to be terrible. (But) the differentiation between emerging markets is going to be critical."

Jay Directo | AFP | Getty Images

Hui added that the risk of outflows is higher for emerging market bonds than equities, given the former have benefited from higher inflows as a result of easy monetary conditions over the past four years.

(Read more: Fmr. Fed Governor Mishkin: Fed got it right this time)

Asian equity markets appeared to take the taper announcement in their stride, with South Korea's benchmark KOSPI index rising 0.7 percent and Malaysia's KLCI gaining 0.2 percent in early trade on Thursday.

Currencies, however, came under some pressure with the Indonesian rupiah hitting a five-year low of 12,190 against the U.S. dollar and the Philippine peso falling to a fresh three-month low of 44.39.

The Fed on Wednesday announced it would to taper its aggressive bond-buying program by $10 billion to $75 billion a month starting in January. The central bank will lower its long-term Treasury bond purchases to $40 billion and mortgage-backed securities to $35 billion a month, both reductions of $5 billion.

After taper, EM differentiation is key: JP Morgan
Tai Hui, Chief Asia Pacific Strategist at J.P. Morgan Funds, says Indian and Indonesian currencies may fall in the short-term but notices that their Taiwan and Korean peers have reacted favorably.

Emerging markets - which benefited from massive U.S. monetary stimulus in the wake of the global financial crisis - had come under heavy selling pressure between May-August triggered by concerns over the central bank cutting back support for the economy and a sharp rise in U.S. Treasury yields.

Dariusz Kowalczyk, senior economist and strategist, Asia ex-Japan at Crédit Agricole says the response of U.S. government bond yields will continue to play a key role in how emerging markets respond to the Fed decision.

(Read more: Now that Fed's out of the way, it's Santa's turn)

"The higher the U.S. Treasury yields move, the more downside for emerging market foreign exchange. The currency market will also be inversely correlated to the strength of the U.S. dollar," he said. The benchmark 10-year note's yield rose to a three-month peak of 2.89 percent.

However, Boris Schlossberg, managing director of BK Asset Management said given that tapering reflects the Fed's rising confidence in the U.S. economy, it may in fact be positive for emerging market currencies.

"Emerging market currencies are a function of growth, so if the U.S. economy acts as locomotive for global economy in 2014, it should be relatively healthy for emerging market currencies," he said.

(Read more: China-focused hedge funds buck market doldrums)

"But if this is just a false dawn, if the recovery sputters out in the first or second quarter of next year - you will see a big decline in emerging market currencies going forward," he said.

—By CNBC's Ansuya Harjani; Follow her on Twitter: @Ansuya_H

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