The Reflation Trade and Emerging Markets
A lot of discussions have emerged in the past two weeks surrounding the near future of U.S equities and a possible pull back for the S&P 500 given the overvaluations on a plethora of equities. Whilst the rise in Treasury yields and the prospect of a sustained steepening of the yield curve with the Federal Reserve pinning short-term rates near zero, has also provided food for thought.
At the start of last week, the U.S. 10-year yield jumped 11 basis points, and this has further stimulated these discussions surrounding a possible surge in inflation, premature monetary policy tightening and a potential pull-back on equities.
Given the general consensus present at the beginning of Q1 regarding emerging markets, and after sustained outperformance of emerging markets for the past months it seems relevant to discuss the effects of these changes in the yield curve on these economies and how a continuation of these trends may or may not present challenges to earlier projections of emerging markets in 2021.
I would encourage you to read a recent article by FinFoc’s Jan Ortonowski as a primer on emerging markets if you haven’t already, where he discusses the strengths of these economies this YTD, whereas I am going to analyse the possible effects of recent market changes in the developed world that could change the outlook on EMs.
Future Outlook on U.S. yields
The yield curve is an important representation of the state of the rates market, as well as being considered a useful tool to predict changes in the level of economic growth. The future of the rates market greatly depends on two important factors: potential changes in the interest rate by the Federal Reserve and long-term expectations of inflation. Therefore, this is strongly linked to monetary policy and investor confidence and thus has long been regarded as an important tool used to forecast changes in the level of economic activity.
The 10-year U.S. Treasury yield rose above 1.3% for the first time in nearly a year last week and the yield curve steepened as expectations of extended fiscal and monetary stimulus alongside hopes of an economic upswing added momentum to the reflation trade. While long-dated Treasury yields have soared, the two-year yield has been anchored by expectations the Fed will keep policy rates near zero for years to come.
A closely watched part of the yield curve, the U.S. 2Yr/10Yr spread is up 4.5% this YTD and more notably around 18% in February so far. [2] (See Figure 1).
The view that the Fed may let the economy run hot has pushed 10-year inflation expectations to their highest since 2014 and another benchmark useful in analysing the future of the rates market has produced telling signs, with the Treasury Inflation-Protected Securities (TIPS) breakeven inflation rate last at 2.245%. Where I refer to the breakeven inflation rate as the market-based measure of expected inflation. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. Since investors’ money is on the line, they presumably have an interest in pricing inflation correctly. It is viewed as a more reliable measure of inflation expectations than those measured by surveys. [4]
Official talks on tapering the Fed’s bond purchasing program, which could commence in the second half of 2021, pose potential downside risks to breakeven rates. According to a report conducted by analysts at Cornerstone Macro said in a research report on Tuesday, regarding the potential withdrawal of the program with time, “That could signal to investors, first that a large buyer in the market is about to become smaller and eventually disappear, and second that the Fed’s resolve to overshoot on inflation may not be very strong, depending on what the outlook for inflation will be at that time.” [5] Though it seems likely the central bank’s debate over bond purchases will commence when it is clear the Fed is on track to meet its inflation and employment goals.
Reflation on Emerging Market Economies
Market conditions in developed countries generally effect emerging economies given the fact that emerging markets have a heavy reliance on foreign investment as providers of liquidity. Liquidity in any market is determined by a few factors including investors desire to trade in the same place and uniqueness of the instruments available in the market. This can explain why a large portion of investing in emerging markets is conducted through Index funds, Exchange Traded Funds, and ADRs in developed nations such as the U.S and parts of Europe.
An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. depository bank representing a specified number of shares of a foreign company’s stock. The ADR trades on U.S. stock markets as any domestic shares would. ADRs offer U.S. investors a way to purchase stock in overseas companies that would not be available otherwise. Foreign firms also benefit, as ADRs enable them to attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges. [6]
It seems the steepening of the yield curve and overall rise in rates in the U.S. could risk the sustainability of the emerging market trade that has proven so popular on the street this YTD. Whereas up until now, investor sentiment towards economic recovery with a strong rebound, alongside a substantial stimulus package proposed by the Democrat office, has led the way in terms of drivers for the trade, though it seems the biproducts of such, namely inflation could spoil the party.
This notion has been proposed by JPMorgan Chase & Co this week, providing a commentary of recent market developments that suggests the hike in treasuries should keep investors on their guard. “If a particular allocation across the risky markets spectrum should be low confidence this year, it is the EM overweight,” JPMorgan’s John Normand wrote in a note to clients last Wednesday. [7]
If inflation starts to pick up again in the U.S and benchmark rates are pushed higher (much of what has been talked about recently), then a continuation in the sell off will encourage investors who piled into higher-yielding securities in the developing world to head for the exit, as the relative appeal of holding them fades.
Whilst Goldman have stated, “a sharp move higher in U.S. rates can drive sharp selloffs among highly positioned high-yielding EM currencies on a tactical horizon,” strategists wrote in a note last Wednesday. These “moves can retrace once the pace of the rate move moderates,” they added. [7]
Though not everyone will take the same view, and there are plenty of valid counter arguments that oppose the notion that higher Treasury yields will drive down the notoriously volatile asset class. Some suggest that capital flows tend to accelerate as the global economy expands, outweighing the negative impact of higher borrowing costs. Whilst the rise in the issuance of local currency debt by EM countries has, in isolation, reduced reliance on external funding. Although it must be said that the overwhelming majority of market moves recently have gone against emerging economies.
Conclusion
In recent years, EM local currency debt markets have attracted flows as markets have opened to foreign investors. However, higher US interest rates improve the relative yield attractiveness of US government bonds and leave EM countries vulnerable to the flight of hot money from foreign investors seeking higher yields.
Khoon Goh, head of Asia research at Australia & New Zealand Banking Group Ltd, said the firm will “turn wary” if the 10-year bond yield breaches 1.50% and starts to head toward 2%, as this will likely lead to bond outflows in Asia. [8] It was trading at around 1.46% Today. Until then, however, “we remain positive on Asian currencies, and see the positive growth outlook for the region outweighing the move in yield,” he said.
This seems to paint the picture for the asset class and all eyes will be on the U.S. benchmark rates as this week draws to a close.
[1] https://www.gurufocus.com/yield_curve.php
[2] https://www.bloomberg.com/markets/rates-bonds/government-bonds/us?sref=dVqp2BYg
[3] https://www.cnbc.com/quotes/10Y2YS
[4] http://www.bondeconomics.com/2014/05/primer-what-is-breakeven-inflation.html
[5] https://www.reuters.com/article/usa-bonds-idUSL1N2KM11O
[6] https://www.investopedia.com/terms/a/adr.asp
[7] https://www.bloomberg.com/news/articles/2021-02-18/reflation-euphoria-may-come-back-to-haunt-emerging-markets?sref=dVqp2BYg
[8] https://www.schroders.com/en/ch/wealth-management/insights/markte/multi-asset-insights-are-emerging-markets-prepared-for-the-eventual-us-rate-hike/