US higher rates could inflict real damage, say Ashmore’s Dehn and Medeiros
Jan Dehn, head of Research and Gustavo Medeiros, Portfolio Manager at Ashmore discusses the battle between bond vigilantes and the Fed.
Bond vigilantes 1 – 0 Fed
The US treasury market is already caught up in an almighty battle between bond vigilantes and the Fed. The bond vigilantes won the first round, when they forced the Fed to U-turn on tapering in September. The risk for the Fed is the long end of the curve. The US economy is heavily indebted and higher real rates can inflict real damage. So when the Fed announced its intention to taper in May, Fed Chairman Ben Bernanke went out of his way to stress that tapering is not the same as rate hikes. Clearly he believed he could control the long end of the curve through verbal guidance. In retrospect, this belief was hubris: Bond vigilantes ignored Bernanke’s rate guidance, and proceeded to push 2s30s to near their all-time high as well as pricing in nine rate hikes by Q3 2016.
How can the bond market defeat an institution like the Fed?
The answer is that the Fed’s power to influence the bond market has become very asymmetric. The Fed is (almost) the only game in town when it comes to buying US Treasuries. In Q2, for example, the Fed was the only net buyer in the market. Therefore, rates can easily go up if the Fed stops buying.
But there are limits to how high long rates will go, because higher yields have effects on the real economy. Remember that QE’s success is not just felt in financial markets – QE has also had three important positive effects on the real economy:
1. QE lowered debt service costs to free up disposable income for heavily indebted households
2. QE helped to clear the mortgage market and in the process the Fed became the economy’s single biggest holder of US mortgages
3. QE increased asset prices to raise wealth levels, though the impact of QE-induced asset price appreciation on wealth is probably less than prior to the 2008/2009 crisis
Like a virus, the Fed learns and adapts. Following the market’s rough dismissal of Bernanke’s verbal guidance in May the Fed will try stronger medicine next time it seeks to taper. Currently the most talked about innovation is to adopt a lower 6% formal unemployment threshold for hiking rates. Thus armed, the Fed is hopes to taper again, mostly likely early in 2014, without blowing up the long end of the Treasury curve. But will a formal lower unemployment threshold really deter the bond vigilantes? We doubt it for three reasons:
1. A lower unemployment threshold is just another verbal commitment. It can be broken at any time. Is a new verbal commitment really going to be credible when the previous one was just shot to pieces? Recently the BOE (Bank of England) and the ECB (European Central Bank) have experienced similar defeats at the hands of the markets.
2. The bond vigilantes know that the Fed has very little concrete ammunition to back its verbal guidance. Once QE is gone the only other tool available to the Fed is twist operations (selling short dated securities and using the proceeds to buy long end bonds). But the Fed’s room to twist has narrowed. Only 21% of the assets on the Fed’s balance sheet are below five years to maturity and some 54% of the assets are already more than ten years to maturity.
3. Finally, there is plenty of liquidity to fund speculation against the Fed and the cost of shorting the long end of the US treasury curve is quite low. The table below outlines the basic calculation. A 6 month short position in long bonds funded by 3 month money market rates will only require a move higher in 5-year, 10-year, and 30-year swap rates of 34bps, 22 bps, and 10 bps respectively to breakeven. Given the low starting point for yields such price increases seem relatively easy to achieve if the Fed announces the intention to taper again.
EM and Tapering v 2.0
If, as seems likely, the Fed will attempt to taper again next year with the result that US treasury volatility increases how will Emerging Markets (EM) react? We see three reasons why EM will not have the same outsized reaction the next time around – technical, fundamental, and valuations. We discuss each in turn.
Barring an almost unprecedented reversal of the outflows from EM in 2013 we should start 2014 with significantly stronger technical than last year. Recall that positioning in EM fixed income was already extended going into 2013 after investors had belatedly chased the opportunity created by the Greek default in Q3 2011. Lower volatility following the introduction of the ECB’s OMT programme was also confused with lower risk in EM and induced additional inflows (in fact risk was largely unchanged).
Then, within the first four months of 2013, technicals deteriorated further as banks and leveraged fast money began to front-run anticipated Japanese real money flows into the asset class. Against this extremely distended technical backdrop, the Fed’s May tapering announcement catalysed 20 weeks of mainly retail and fast money outflows into a market with few buyers due to low summer liquidity and big uncertainties arising from US political issues, Fed succession, and expectations of tapering by September. In other words, the outsized reaction in EM fixed income relative to other fixed income markets was almost entirely due to bad technicals. By contrast, the technical picture as we approach 2014 is entirely more favourable.
In brief, EM asset prices went down over the summer, but fundamentals improved. But this general statement fails to do justice to the complexity of the fundamental picture in EM. There are more than sixty investable countries and hundreds of investable corporates in EM. And the asset class is growing very fast, rising by USD 1.3trn in the past 12 months alone. The variation in credit quality across the vast universe is enormous, far wider than, say, that of Germany and Greece. China bears little resemblance to Paraguay, Ecopetrol is a completely different company from neighbouring PDVSA, and Korea’s Samsung bears little resemblance to Nigeria’s GT Bank, Ukraine’s MHP, or Jamaica’s Digicel, though all four are well run companies.
At 4.5%, EM growth in 2013 has been disappointing. But EM growth disappointed for the same reasons that growth in developed economies disappointed. The main culprit was a dip in the global manufacturing cycle, which took hold in late 2012 and extended into Q1. Europe and the US were similarly very weak in Q1. For example, US growth was expected to be 3.5% growth in Q1 but was revised to just 1.7%.
The final reason why we think investors should be less wary of tapering by the Fed in 2014 is that EM valuations are far more attractive. Local currency bond yields have re-priced back to 2003-2007 average levels. The last time EM bond yields were at these levels was when 10-year US treasury yields were close to 4.5% and 5-year US treasury yields averaged nearly 4%. Today, the latter are trading closer to 2.7% and 1.4%, respectively.
Corporate bonds in EM have also cheapened significantly compared to identically rated US corporates. EM corporate high-yield and high-grade corporate bonds are trading at 1.6 and 1.9 times wider spread than identically rated US companies, respectively. Finally, EM sovereign bond spreads have blown out to more than 300bps over US treasuries.