In my previous post I briefly mentioned the cliche, which is the sell-off in US Treasuries and how many people treat it as the biggest impending risk to their portfolios.
This subject has been recently explored by the IIF in its regular update on capital flows to emerging economies (pdf here). In Box 2 on page 7 you can find an analysis of what happened back in 1994 and let’s just say it isn’t a pleasant read. Many conclude that considering that foreign positioning in EM bond markets is considerably higher, any move in the US curve will be a calamity. Historical evidence makes it difficult to argue with this view but I think some people have not really thought through the whole mechanism.
Consider the following example. In recent days I had a “priviledge” of interviewing a few analysts. When asked about the general market direction they all replied that they were bullish now and bearish later. This is by the way the standard response of a sell-side credit analyst who wants to get his clients to buy but also to sound prudent and risk averse. I was tempted to cut those conversations short very quickly but eventually decided to explore motives of such a novel recommendation. So I asked what would be the trigger for the said bearishness “later”. The answer was the same – a sell-off in USTs and ensuing outflows from emerging markets. I managed to resist quoting Homer Simpson (“Doh!”) and started digging deeper. Note that people I spoke to had an important piece of evidence at their hands, i.e. the recent outflows from hard currency EM debt as reported by the EPFR.
When asked about what sort of levels in USTs they had in mind, the replies varied between 2.30 and 2.50 for the 10yr. Now, let’s stop and think a little about what this really means. The chart below shows the current UST curve along with the 1yr forward one.
As you can see, the market is pricing in a shift up of the UST curve by around 27bp in the 10y. In other words, this means that if you sell the 10y bond here and the yield doesn’t go up by at least 28bp in the next twelve months, you effectively lose money. The forward curve is the quickest and the simplest approximation of the carry of the position. You don’t just have to guess the direction but you also have to beat the forwards.
Disclaimer for geeks: I know that simply subtracting 10y yield from the 1y forward is not exactly the same thing as a carry but it will have to do for the purpose of this post.
If you think that 10y US yields will sell-off by 30bp or so then guess what – the market is already pricing that in and nothing spectacular has happened (yet!). Oh and also, in 2011 the difference between the 1y forward 10y yield and spot 10y yield was at times as high as 50bp.
In my opinion, if 10y yields in the US increase by 30-50bp in the next twelve months or so it will be one of the best things that can happen to emerging markets debt. I strongly believe that such a scenario would lead to further tightening of EM-DM spreads because:
- it will mean that the world economy has actually picked up but not sufficiently to bring about significant inflationary pressures
- the US economy will have accelerated but not sufficiently to remove the acommodation or end QE
- problems in the eurozone would remain contained (if we get a return to the acute phase of the EMU issues, don’t count on the spike in US yields!).
The market is perfectly capable of dealing with a slow increase in US yields. Also, everyone is very well aware of this risk so talking about it is a moot point.
How to trade this? Contrary to what may seem from this post, I am actually quite concerned about a sell-off in USTs, mainly because of the convexity effect related to mortgage papers. It is totally conceivable that one day a huge flow goes through the market and the said 28bp happens in a few hours rather than a year, like the market implies. Therefore, I still think that investors need to be careful about duration in emerging markets, particularly the ones where you see some signs of activity picking up. I would very much rather own short duration debt of high yielding countries (think 3y Ghana) than long duration debt of low yielding countries (think Poland). That being said, given the technical position of many funds, my base case scenario is that a US-induced sell-off in EM debt will be a good opportunity to go long.
Finally, I believe that investors should selectively look for inflation linkers in emerging markets but this is a story for the next post… Meanwhile, check out this recent story from Bloomberg: Bond Traders Whip CPI Angst as India to Hungary Cut Rates.