The long end keeps on rising

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The long end rises (even more)

The 10-year Treasury yield hit 4.19 per cent yesterday and is now 56 basis points above its low on September 16, the day before the Fed cut rates by half a percentage point. That’s a big fat move, and it invites speculation about what is going on in traders’ minds and how much higher rates can go. 

The last time we wrote about the rising long end, two weeks and 16 basis points ago, we argued that the move mostly reflected higher expected rate volatility, given high uncertainty about the path of Fed policy.

Since then (as discussed yesterday), fears of an overheating economy and “no landing” scenario have gained traction. So perhaps it is inflation worries that are ramping up, rather than rate uncertainty? But it remains the case that two-thirds of the move in nominal yields has been driven by higher real rates (as proxied by inflation-protected yields), and only a third by higher break-even inflation.

Arif Husain, head of fixed income at T Rowe Price, argues that the long end will test 5 per cent in the next six months. Inflation will be a secondary cause. The primary one is simply rising supply and falling demand for Treasuries. US government deficits are flooding markets with Treasuries at the same time as quantitative tightening removes a big buyer from the market. At the same time, as the Fed cuts rates, inflation expectations are rising; Husain expects them to increase further. All of this means that, even if the Fed makes another cut or two to the policy rate, long yields will continue to rise. 

Arguments like Husain’s are bolstered by the possibility — increasingly likely, according to models and betting sites — of a Republican sweep in the election next month. The consensus is that this would mean sustained spending, lower taxes and wider deficits. Higher long yields reflect people “frothing at the mouth about the return of [Donald Trump]”, says James Athey of Marlborough Group. Athey isn’t fully convinced about a post-sweep fiscal expansion, given the likelihood of a very small Republican edge in the Senate. All the same, he is moving away from duration and credit risk because he thinks the market has underpriced the small but real chance that the Fed will have to reverse course in the face of a no-landing scenario. A return to rate increases “would take a sledgehammer to risk”, he thinks, while pushing up the dollar. 

On the opposite side of the argument from Husain is Bob Michele, who runs fixed income at JPMorgan Investment Management. “The market tilted too far to ‘inflation will be a problem’, ‘too much issuance’, ‘there will be a sweep’ — it’s just a lot of profit-taking,” he told Unhedged yesterday. The Treasury market was overbought going into September’s Fed meeting. Traders, having bought the rumour of 50 basis points, sold the fact. 

Despite strong jobs and retail sales reports, Michele said, the basic trends that support a stable 10-year yield remained in place. Core personal consumption expenditure inflation, if you annualise the monthly changes in July and August, is right at 2 per cent, and consumer spending is softening gently. Households and small businesses are feeling the impact of higher rates. “You have to dissociate a market consolidation from what is going on in the real economy,” he said.

What if there is a Republican sweep, though? Michele points out most polls still have the race as a toss-up between Trump and Kamala Harris. That said, “if the Republicans sweep, you have to revisit what stimulus will be, taxes, spending — what the Treasury has to fund. You are headed for five”.

Emerging markets

Back in June, we wrote that fundamentals were starting to improve for emerging market debt: debt-strapped countries had avoided default and the broader growth outlook was improving. That has mostly held true since. Add to that the Fed’s jumbo rate cut, which made EM fixed income more appealing, and China’s recent stock rally, and it has been a good couple of months to be in both emerging market bonds and equities:

JPMorgan’s Emerging Markets Bond ETF, which tracks a portfolio of emerging market sovereign and corporate debt, has almost kept pace with high-yield US corporate debt, but has fallen off a bit recently:

Headlines have been touting this reversal of fortunes, but the picture is complex. China has been responsible for much of the hype, but China’s surge has flatlined as the Chinese government continues to equivocate on stimulus. EM with China has outperformed EM ex-China recently, but is starting to slip:

China is so big that it has its own gravitational pull; bundling it with other EMs makes little sense. But even without China, the MSCI index is not terribly coherent. After India, its largest allocations are to Korea and Taiwan, both advanced economies. And even the “true” emerging markets are not moving as one. For example:

• South Africa’s stock market has had a fantastic run, even beating the S&P 500, as the unity government has surpassed expectations.

• Indian equities have had a strong run since April’s election, despite initial investor concerns over a divided government. But the index has been falling since September amid a less-than-thrilling earnings season, and as foreign investors have switched back to Chinese equities.

• Brazil’s stock index has been down over the past six months despite a hot economy. It may stay down, too: Brazil’s central bank raised rates again last month.

• Mexico’s market took a nosedive after its June election, and has been mostly falling or sideways ever since.

• Saudi Arabia’s main companies, mostly in oil and commodities, have performed poorly as global oil prices have been down and as Saudi Arabia has ceded market share to non-Opec countries as well as Opec countries that have “defected” from production caps.

These economies and markets do have one thing in common: just as the Fed’s jumbo rate cut and cooling inflation proved a boon to EMs, a no-landing scenario in the US would pile pressure on them. If the Fed keeps rates where they are for longer, or if it has to raise rates, EM countries and companies will struggle to access capital markets. We will also see a stronger dollar, which will raise debt servicing costs and hinder growth. EMs, unfortunately, remain a most acute barometer of the US rates environment.

(Reiter)

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