The fear of tapering took a slightly different form in the context of local-currency bonds as opposed to USD bonds from Asia. In case of USD bonds, the question was the potential for fixed income as an asset class to produce returns in the face of rising rates; in case of local-currency bonds, the issue was linked to the potential for fund outflows from emerging-market economies, triggering volatility in currencies, equities and bonds alike.
Over the next few months, there are many flash points for emerging markets, including India, Indonesia and Brazil. The first is the next round of negotiations in the US for the debt ceiling in January. Then comes the potential beginning of tapering by the Yellen Fed, some time in the first quarter. After that, the national elections in India (before May 2014), the presidential elections in Indonesia (July 2014) and the general elections in Brazil (October 2014). Each of these events has the potential to keep alive the volatility that we have witnessed this year.
The current mood in the fixed-income markets is one of relief (that the tapering is not imminent) mixed with foreboding (that rates are eventually set to rise further). At the moment, the market is still in a healthy state, as evidenced by the flow of new issues and the stability in credit spreads.
Beyond the next few months, the shape of the fixed-income markets will depend on the speed with which interest rates normalize. I believe that even when tapering gets underway, it will be a carefully managed process by the Fed. The Fed has made it abundantly clear that any withdrawal of monetary stimulus will be data-dependent. The Fed has a lot of leeway in deciding the speed of tapering. While it may start with a reduction in QE of USD 10 billion a month, it may not continue to taper at a rapid pace if the economy begins to falter. The Fed will also be watching the behavior of long-term rates, both as an indication of the market reaction, and more importantly, as a key variable that could affect the mortgage rates and the housing recovery.
As a result of this carefully managed process of tapering, fixed income investors should be able to adjust their portfolios over the medium term. If there is a sudden jolt to the rates, like it happened during May-June 2013, leading to losses in the portfolio, there is likely to be a temporary pullback. If rates adjust gradually, over the next 2-3 years, there will be enough breathing space for investors to realize their maturing investments and reinvest them at higher yields, and thereby adjust their portfolios for rising rates.