2015 will be characterised by increasingly disparate yields and by lower currency volatility. Dollar-denominated emerging assets should hold up well in that environment. In contrast, assets tied to commodities (currencies or debt of commodity exporting economies) are not well positioned. Local nominal rates should outperform inflation-linked bonds on the back of a moderation in inflation.
In addition, we expect by a broader dispersion of spreads as a result of an increase in the divergence of fundamentals, this will require more selectivity. The probable rise in the volatility of risk-free assets, particularly Treasuries could reinforce this trend. On the other hand, the risk that volatility will return to emerging currencies is more limited given the tailwinds of pro-cyclical monetary policy in the G4 and of the recent drop in energy prices. This is positive for local debt, which maintains an extremely attractive carry.
2014: another year of rising risk premiums
This year we have seen that performance hierarchy has been inversely correlated with carry. Indeed, it is assets with the lowest yields, i.e. betterquality government bonds, that are closing out the year with performances well in excess of 10%. This is the second time that the fixed-income markets have performed in this way in the past five years, with the previous occurrence dating back to 2011. In both cases, questions about the normalisation of the Federal Reserve’s key rates have triggered a significant return of bond volatility. If past trajectories are a guide to future trends, this means next year could be a promising one for emerging sovereign debt issued in reserve currencies or local currencies.
The US dollar is to appreciate
But the analogy with 2011 ends at the triggering factor, i.e. the normalisation of the Federal Reserve’s policy. We note at least three substantial differences. First, the nature of the macroeconomic risks on a global level has totally changed. Visibility over the Federal Reserve’s strategy has improved, as evidenced by the virtually non-stop decline in the economic policy uncertainty index in the United States1 . Second, the US economy has once again assumed its role as driver of the global economic cycle, against a backdrop where Europe is still struggling with the risk of deflation and the emerging economies are trying to tackle their imbalances. The consequence of this configuration is that:
i. a medium-term return to orthodox US monetary policy has been made more credible, and
ii. dollar-denominated assets attractiveness will strengthen.
The US dollar has signifi cant potential to appreciate, from which dollar-denominated emerging assets should benefit. In contrast, assets tied to commodities, such as the currencies or debt of commodity-exporting economies, will be hit hard by this trend. Another consequence that should be expected, which results from the risk of moderating inflation against a backdrop of a downturn in commodity prices, is poorer performance by inflation-linked bonds compared to local nominal rates.
The term spread of the US curve is expected to widen next year...
The first problem faced by the emerging debt markets is the outlook for an increase in the US term spread. This is the first risk that comes to mind when considering the outlook for a normalisation of the US monetary policy. However, a steepening of the US yield curve due to an increase in long rates (bear steepening) is far from a certainty in 2015.
Against all expectations, one of the recent anomalies observed is the negative correlation between the short and long segments of the US yield curve. Calculated using a rolling 200-day window, this correlation has sunk from a high point of 0.9 in October of last year, to a minimum of -0.7 reached in late August of this year – a 25-year low. Since then, it has recovered slightly to -0.6.
In fact, the forward spread of the US curve between 2 and 30 years maturities has narrowed by about 100 bp over the year, from 360 bp to 250 bp, while the change in expectations resulting from the prospect of future normalisation should have caused a steepening, which we estimate at about 30 bp. This would have brought the US 2Y-30Y spread back to its 2011 level of 390 bp.
There are several factors actually arguing in favour of a lower spread in the US, including:
Yet, this anomaly, in our opinion, has built up on the grounds of an expected large-scale expansion of the ECB balance sheet. The high correlation between euro one-year forward rates and US long-term rates does support this potential causality. As a consequence, the ECB maintaining its current strategy of expanding its balance sheet without buying sovereign bonds could lead to a rise in the correlation between the short and long segments of the US curve. With this prospect in mind, we, thus, anticipate the 2-to-30-year term spread in the US to expand by 100 bp over 2015, reaching around 340 bp.
These developments are important for dollar denominated emerging debt. Since an unorthodox policy was established in the US, the US curve term spread and the yield ratio of the dollar denominated sovereign debt index (EMBI) have trended in an opposite way (see Box 2). Beginning with the relationship observed since 2010 between this forward spread and yield ratio of dollar-denominated emerging debt, we anticipate 12-month performance of 2.5% for the EMBI index, for a spread target of 320 bp.
This forecast is based on a spread carry of 3.3%, dragged down by slightly negative performance from Treasury bonds, since our central scenario is pricing in a 10-year target rate of 2.8% by the end of 2015. Given that this relationship is likely to change because of the Fed’s return to orthodoxy (see Box 2), we cannot rule out improved performance of up to 3.5%.
A rise in spread dispersion is yet bound to happen
What is more, 2015 will bring another increase in sovereign spread dispersion and volatility. The increased spread dispersion will be driven by two distinct phenomena - first, increased volatility of US bonds and second, the deterioration of emerging fundamentals.
The mechanism underlying this rise in volatility has been detailed before. It should be compared with the expectation of a heightened correlation between the short and long segments of the US rate curve. As shown in graph 6, expectations of the future trajectory of key rates – assessed here by the one-year forward rate – are a good advanced indicator of the direction in which bond volatility is moving. Thus the dithering that will surely come over the Fed’s return to orthodoxy will result in more bond volatility.
The other factor in spread volatility is the deterioration of emerging fundamentals. On the front line are commodity producers, particularly in the oil economies. Our scenario on emerging economies (Article 4, “Emerging economies: Governments must now meet their commitments alone” ) stresses that keeping oil prices low is likely to weigh on the fiscal balance of the oil economies. The recent drop in oil prices will lead to wider spreads between oil-exporting economies, depending on their domestic economy’s degree of diversification. The more diversified an economy, the greater its ability to mitigate the decline in its oil revenues.
Small oil-exporting economies such as Venezuela are particularly vulnerable. Venezuela’s sovereign spread recently fell 300 bp, but at 1500 bp it is still close to a six-year high. Between them, Argentina and Venezuela reintroduced the risk of default to the emerging debt markets this year. Another recognised risk in our scenario is the slowdown in China, which could weigh very seriously on the Asian capital markets.
Local rates will initially be underpinned by low surplus volatility
As we highlight in our scenario, the drop in oil prices should mean that inflationary tensions are likely to be reduced, particularly in economies vulnerable to substantial macroeconomic imbalances, such as South Africa, Turkey, Indonesia, India, Brazil and Russia. A stabilisation of price trends – which is already well underway in Indonesia – should pave the way for a reduction in inflation expectations and, as such, an increase in real rates. Against this backdrop, the ability of central banks to maintain a credible target-inflation policy will be decisive. On this point, South Africa and Turkey remain vulnerable. Outside these two economies, inflation-linked bonds remain attractive for Latin American mining economies such as Chile2 insofar as the downside risk on their currencies is able to fuel inflationary tensions. More generally, in anticipation of continued moderation of global inflation, we prefer nominal local rates to inflation-linked bonds.
With regard to debt issued in local currencies, this year – as in 2011 – has reiterated how important emerging currency volatility can be. Reassessments of global cyclical risks of the scale that we have witnessed are often the most costly because currencies with the highest betas are also the ones for which hedging is the most expensive. As a result, due to fears of seeing their investment portfolios take a major hit because of a volatility shock, investors are quickly withdrawing from high yield debt. Consequently, in the current environment that remains characterised by still accommodative G4 central banks and following the shot in the arm for growth from the recent drop in energy prices, the risk that volatility will return to emerging currencies is limited. Furthermore, the profitability spread of the main emerging currencies compared to the dollar on the long segment of the curves is not expected to narrow substantially in light of the information we have provided on the expected forward-spread trend.
As we observed last month, the appeal of emerging currencies resides in their ability to be little influenced by the divergences between central banks, particularly in the G4. During the recent cyclical correction, implied volatility of emerging currencies spread relatively little from that of G7 currencies. With a carry of 6.4%, we are anticipating a continued decline in yield and a target yield of 6%. This amounts to anticipating performance of 6.4%, to which a 2% duration effect must be added, for a total of just over 8% in local currencies in 2015. At this stage, only a more intense slowdown in China could trigger a further correction on emerging currencies.
1 The uncertainty index on US monetary policy is based on a tally of the number of news articles in the United States that contain at least one of the terms in the following three sets: (i) economic, economy, (ii) uncertain, uncertainty, (iii) Legislation, deficit, regulation, Federal Reserve or White House This tally includes more than 1800 news outlets for the US index, collected in the NewsBank Access World database. Source: http://www.policyuncertainty.com
2 Inflation in Chile was 4.9% in October compared to an official inflation target of 3% +/- 1%.
One of the recent anomalies observed is the negative correlation between the short and long segments of the US yield curve
What is more, 2015 will bring another increase in sovereign spread distribution and volatility
The recent drop in oil prices will lead to wider spreads between oil-exporting economies