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Emerging debt: 2015 will be characterised by lower currency volatility, but larger yield dispersion

The essential

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.

Breakdown of emerging debt index performances

Emerging debt in reserve currencies is ending 2014 on a relatively positive note in terms of performance in dollars. As of the end of October, the EMBI Index spread was 338 bp, about 34 bp above its level at the beginning of the year. This increase has caused an estimated negative impact of -2.7% year-to-date, which is offset by credit spread carry trades. Ultimately, the index’s performance comes out slightly below that of US long-term rates at 8.3% due to eroding appetite for risky assets. 

The performance of debt in local currencies is much less appealing once it is expressed in dollars. As of the end of October, cumulative performance stood at 1.3% after reaching 6% at the end of June. The re-assessment of cyclical risks related to the slowdown in China and the European economies, has led to a sharp decline in emerging cyclical assets and specifi cally currencies. At the end of October, the gain in local currencies related to carry was estimated at 5.8% and the gain related to the 37 bp decline in yield was estimated near 2%, all of which was offset by a 6% shock on 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.



Definition of the yield ratio

Yield ratio is a standardisation of the credit risk premium. It consists of expressing the credit spread as long-term rate units. As such, it is the ratio of the credit spread to the 10-year rate.

Behaviour of the yield ratio and the term spread from historical data

Empirical observation of the relationship between the term spread and the yield ratio is difficult to ascertain from historical data. However, we observe that a rise in the term spread is often preceded by a substantial increase in the yield ratio or, equally, in credit spreads. The most immediate interpretation of this relationship is rather direct. In an orthodox monetary policy regime - the only one available in historical data - credit spreads tend to increase before the forward spread. Indeed, before monetary conditions tighten, credit conditions will worsen. This time lag occurs because the continued rise in credit demand generally leads to an increase in credit risk premiums (credit spreads) in anticipation of a risk that the credit quality of the borrowers’ balance sheet will deteriorate.  It is only subsequently that the central bank will undertake a cycle of raising its key rates to counter any inflationary tensions that may arise due to brisk demand. Anticipation of this tightening cycle is the reason for the rising forward spread, through a revision of future anticipations of short-term trajectories.

In an unorthodox monetary policy regime, i.e. when the central bank’s key rates are zero, and specifically in cases where the central bank makes use of quantitative easing by buying sovereign bonds, the credit spreads and the term spread are correlated. When investors anticipate the launch of a new long-maturity sovereign bond buying programme, the term spread declines as long-term rates fall. In return, this decline in long-term rates increases the price of risky assets and, in particular, credit assets leading to a decline in credit spreads. In contrast, the anticipation of an end to the buying programme leads to expectations of future trajectories for short-term rates being revised. This change in the term spread expectations component leads to both a rise in that spread and upside pressures on credit spreads, by means of an increase in risk-free long-term rates.

There are several factors actually arguing in favour of a lower spread in the US, including:

  • eroding potential for macroeconomic surprises to the upside;
  • risk premiums are less and less attractive for US risky assets ( equities and debt)
  • the rise in risk associated with the Chinese slowdown, which could create turbulence on the Asian credit markets; and
  • last but not least, we believe that a rise in rates by the Federal Reserve in 2015 is relatively unlikely.

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%.


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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



Marc-Ali BEN ABDALLAH, Senior Analyst, Investment Solutions
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