By Krista Hughes
MEXICO CITY (Reuters) - Mexico and Peru's popularity among foreign investors means they are among the emerging market economies most exposed to losses when the United States finally moves to take its foot off the monetary accelerator.
History shows that when U.S. interest rates jump - widely anticipated when the Federal Reserve begins reducing its $85 billion a month bond purchases - new foreign investment in Peruvian and Mexican financial assets drops by almost two-thirds.
In what many see as a dress rehearsal, worries that the Fed might slow buying later this year pushed Mexican 10-year yields up almost 100 basis points in May. The rise was twice the jump in U.S. Treasuries.
Bonds in Brazil, Colombia and Peru also sold off and major Latin American currencies fell on average 5.5 percent on the mere hint of a limit to the cheap cash that has pushed many emerging markets to record highs.
Sound fiscal policies and sensible economic management had turned Latin America from a basket case to a favored investment bet over the last decade, especially given low yields elsewhere.
Investors, who have plowed $400 billion into Latin American markets since 2008, said buying-in had peaked and that the market sell-off in May would likely be repeated when the Fed eased back.
"I think this was a preview," said Michael Gomez, co-head of emerging markets at bond investment giant PIMCO. "With the smaller size of some of the markets, those dynamics can tend to be self-reinforcing."
Latin America has outperformed other emerging markets in attracting foreign investment over the last two years and economists say countries with the highest inflows may see the strongest outflows when the wind turns.
Mexico, with its close ties to the United States, has been the biggest magnet for Latin American portfolio flows since 2009, with foreign ownership of local bonds close to 40 percent. Peru and Chile lead taking all foreign flows into account.
Reuters' analysis of data shows that a one percentage point rise in U.S. 10-year yields since 1995 is typically followed by a 63 percent drop in net, non-foreign direct investment inflows to Mexico. Taking inflows over the last 12 months, that would be equivalent to a $50 billion fall.
In Peru, where foreigners own a whopping 57 percent of local currency debt, a comparable rise precedes a 61 percent drop in inflows, while a 40-48 percent fall could be expected in Chile, Colombia and Brazil, which has just dropped a tax on foreign investment in domestic bonds to attract more capital.
The punishment inflicted on Mexico from a half a percentage point jump in U.S. 10-year yields seems to show history repeats.
Foreign holdings of longer-term bonds dropped 18.3 billion pesos ($1.4 billion) from a peak on May 10; 10-year yields rose 22 percent; the spread over Treasuries rose 65 basis points, although it remains near historic lows, and the peso fell more than 6 percent.
"Mexico is one of the most crowded trades, if not the most crowded trade. It's the most liquid currency in emerging markets, so it's going to suffer for those reasons," said Aberdeen Asset Management portfolio manager Kevin Daly, who expects another 40-50 basis point spike in U.S. yields if the Fed moves to exit in September.
Nomura analyst Benito Berber said that since Mexico's peso had only given up just over one-third of the last year's gains in May, it might have further to fall - along with Chile's.
In fixed income, only Colombian bonds fell more than Mexico's last month but PIMCO - which Thomson Reuters data show has $3.6 billion invested in Mexican bonds and another $1.2 billion in Colombia - said both were well-placed for turmoil.
"They have a number of policy levers they can utilize or balance sheet anchors that represent dry powder to withstand market volatility. So I am a little less worried about them," Gomez said.
Another potential cushion is Bank of Japan stimulus keeping global liquidity ample even if the Fed changes course, although it may not stop foreigners dropping local currency debt if exchange rate weakness cuts the value of their investments.
Peruvian Finance Minister Luis Castilla downplayed risks to his country from a Fed exit and welcomed the sol's easing from 16-year highs.
"We're a country that has been running fiscal surpluses," he told Reuters. "We are not a country that will need to be tapping markets such as other countries in the region. That gives us some comfort."
But Peru is also pressured by slower growth in China, undercutting the high commodity prices that have buoyed its economy. The minerals exporter has just posted its first quarterly trade deficit in more than four years and economists are trimming growth forecasts.
To some investors, the sell-off in May was a wake-up call to those who had preached that emerging markets were the new global safe haven amid ongoing weakness in developed economies.
"It seems to suggest Latin America is still the 'high beta' play on what's happening in the U.S.," said Frances Hudson, global thematic strategist at Standard Life Investments, referring to relative volatility.
"Investing in Peru or Brazil is not a risk-free option, and perhaps it was timely that people were reminded of that." ($1 = 12.7216 Mexican pesos)
(Additional reporting by Michael O'Boyle; Editing by Kieran Murray and Cynthia Osterman)
(This story is refiled to correct dollar amount in second paragraph to $85 billion)