How emerging markets are paying the price of skittish bond investors
Nicholas Spiro says debt investors are being unduly pessimistic about the impact of the US Federal Reserve’s interest rate hikes
Spare a thought for the Federal Reserve. Ever since the US central bank kicked off its interest rate-hiking cycle in December 2015, it has struggled to elicit the appropriate reaction in financial markets.
Despite four rate hikes between December 2016 and December 2017, financial conditions – a gauge of how stimulative markets are for economic growth – became looser, the opposite of the intended effect. Last year, the dollar index (a measure of the performance of the greenback against a basket of its peers) tumbled by nearly 10 per cent while the benchmark 10-year Treasury yield barely budged.
In a sign of the extent to which markets disbelieved the Fed’s increasingly hawkish stance, emerging markets’ bond and equity funds attracted a record US$200 billion of inflows last year, according to JPMorgan.
This year, however, the predictions of the Fed and those of the bond market have converged significantly, so much so that investors are anticipating a sharper tightening in monetary policy than the Fed itself. According to Fed funds futures, which are contracts that investors and traders use to bet on movements in rates, markets see a slightly higher chance of three more rate hikes this year, as opposed to the two additional increases forecast by the Fed.
The dramatic repricing of US rate expectations in the space of just several weeks – in early April, bond investors were still assigning a less than 20 per cent probability of three more rate hikes this year, compared with 45 per cent at the end of last week – has had a far more potent effect on financial conditions than the Fed’s own policy tightening.
The facts speak for themselves.
The 10-year Treasury yield, a crucial benchmark for global markets, has surged by more than 25 basis points since early April, and last Friday hit a fresh seven-year high of 3.12 per cent in early trading, surpassing its level at the peak of the “taper tantrum in early 2014.
The sharp rise in 10-year yields is being driven partly by an increase in bond investors’ expectations for US inflation, with the 10-year “break-even” rate – a measure of market expectations of average inflation over the next decade – reaching its highest level in four years last week.
This abrupt reassessment of rate expectations has contributed to a 4.7 per cent increase in the dollar index in the past month, putting emerging markets under significant strain.
Returns for emerging-market bonds, currencies and equities since the beginning of this year have been driven deeply into negative territory, with emerging-market bond funds suffering outflows for four straight weeks, their longest streak of redemptions since 2016, according to JPMorgan.
Make no mistake, bond investors’ precipitate fears about tighter US monetary policy have knocked the stuffing out of one of the most popular asset classes and have become the main source of turbulence in markets.
What is particularly worrying is that debt investors’ expectations of a faster pace of rate hikes this year are growing in tandem with mounting concerns that the ageing global economic and business cycle is teetering on the edge of a downturn.
According to the results of this month’s global fund manager survey, published by Bank of America Merrill Lynch last week, only a net 1 per cent of investors believed the world economy will strengthen in the next 12 months, while just a net 10 per cent of respondents believed corporate profits will improve, the lowest proportions since 2016.
This suggests that the sudden repricing of US rate expectations is not a reflection of optimism about brisker growth in the coming years but is instead a sign that bond investors believe the Fed will tighten policy too aggressively and end up weakening the economy. As I noted in an earlier column, certain esoteric parts of the US debt market have started pricing in rate cuts as early as 2020.
Last year, the Fed would have welcomed a much higher market-implied probability of rate increases. Yet instead of a complacent bond market, the Fed is now faced with an overly sensitive market that expects the US central bank to commit a “policy mistake”, now the biggest threat to markets, according to the results of the Bank of America Merrill Lynch survey.
While it is reassuring that bond investors are no longer underestimating the Fed’s resolve to raise rates, the price of this new-found vigilance appears to be undue pessimism, as policymakers in emerging markets would doubtless agree.
Nicholas Spiro is a partner at Lauressa Advisory