Article / 10 January 2018 at 11:00 GMT

Weekly Bond Update: The EM rally, version 2.0 — #SaxoStrats

Head of Fixed Income / Saxo Bank
Denmark
  • Emerging market bond rally in the crosshairs
  • Rising US yields pose a danger to EM
  • 'We are looking at a tight market with less upside potential'
Emerging markets
Clouds over Table Mountain, Cape Town: Emerging market bonds were strong in 2016-17, but rising US yields and market fundamentals could pose problems this year. 
Photo: Shutterstock

By Simon Fasdal

This year started with a bang for emerging market bonds with the major EM trackers making new all-time highs in the first days of January despite the fact that core bonds' performance has been challenged by an overall landscape of increasing yield.

But is the present development sustainable?  

The 2016-17 EM rally was interrupted just once by Federal Reserve sabre-rattling, and has brought nice returns (even double digits in some regions). Some of the same factors that propelled the last six-month rally will continue to support the asset class in the short term, the most important being a lack of alternatives due to low global yield curves, strong or stable local currencies due to a weaker dollar, positive developments globally with (still) little inflationary pressure, and the fact that most EM are now more mature and their financial infrastructure much more aligned with global capital markets and standards.

Eventually, some of these factors will change. Rising US yields are a particular danger. The challenge right now is the very flat US yield curve; this either reflects a lack of faith in the Fed and an upcoming slowdown, or on the other hand an accumulation of yield pressure from the short end resulting in "catch-up effect" conditions in longer US and global yields (with a sudden spike if inflation and more Fed hikes become reality – think Deepwater Horizon in the fixed income space). 

As stated last week, fear is nowhere to be seen. If and when it materialses, it will likely do so at the last minute due to continued global quantitative easing, the consequent abundance of investible cash, and the epic resilience this creates.

The EM rally:

EM Rally

Create your own charts with SaxoTraderGO click here to learn more

Source: Saxo Bank 

That leads me to another another risk factor for EM assets: the size of of the market. EM corporate bonds have tripled in size since 2007, but the capacity of the market place has unfortunately not increased  (the "marketplace" being equal to the number of participants and their capability to take on risk). 

Even though there are more players in EM debt today, trading desks have downscaled in risk terms, resulting in less-committed market making when volatility or stress kicks in. 

Investors should therefore work with a liquidity premium of a certain size when entering EM.

As for the question of EM sustainability, one thing to determine is whether risk/reward looks viable from a top-down perspective. One simple approach here is to examine spreads versus US yields. 

In that context, I believe we are looking at at a tight market with less upside potential; the only feasible case would be a "non-event 2018" – a year of sideways markets, no sign of an inflation breakout, and more free puts from central banks.

EM bond spreads versus US two- and 10-year yields:
EM spreads vs US Yields
Source: Bloomberg
 
Having identified these risk factors, I remain a big fan of EM bonds as an asset class. EM bonds deserve a place in investor portfolios as they remove some of the inherent "homeland bias" and because they have been proven to have a relatively low correlation to shocks in other regions and assets.

— Edited by Michael McKenna

Simon Fasdal is head of fixed income strategy at Saxo Bank

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Tradingfloor.com permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Tradingfloor.com and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Tradingfloor.com is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Tradingfloor.com or as a result of the use of the Tradingfloor.com. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through Tradingfloor.com your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. Tradingfloor.com does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail