While the U.S. economy appeared to hold its breath in advance of Jerome Powell’s first major foray into the Fed’s spotlight, fixed income markets dealt with other matters, including...
...volatility elsewhere. Monday’s Facebook-led downdraft in U.S. equities briefly reignited volatility; the S&P 500 fell just over 2% before regaining its poise, albeit at a slightly lower level. That could help explain the slight upward move on the longer end of the U.S. yield curve, but a more likely culprit was the rising 3-month U.S. dollar Libor rate —a possible sign of market-induced monetary tightening, and therefore a potential drag on growth.
But other sources of twitchiness weren’t hard to find. The ostensible settlement of the terms of disengagement between the UK and the European Union generated a temporary spike in the British pound vs. the U.S. dollar – that is, until it became clear that the border issues between Ireland and Northern Ireland remain unresolved. Tough talk about tariffs at the G-20 summit in Brazil also offered little comfort to markets. The possibility of an unusually long and contentious government formation in Italy did little to bring tranquility to markets. While Italian President Sergio Mattarella let it be known that he is ready to allow post-election passions to cool, at least until July, battling minority party heads Luigi Di Maio (Five Star Movement) and Matteo Salvini (Northern League) will likely continue to stir the pot.
On the Rise: U.S. Dollar Funding Costs
U.S. short-term rates have followed the Fed Funds target rate upward (see chart), bringing with them the reality of higher borrowing costs for short-term loans. That’s to be expected. The profitability that comes with those higher rates has certainly been a boon to the financial sector. However, the profitability of loans is driven by the spread between funding costs and lending rates. The cost of funding is closely linked to the U.S. overnight interest rate, as determined by a combination of the Fed Funds rate and its market.
The closely-watched Libor-OIS swap rate tracks this relationship, such that a higher swap rate indicates more expensive funding.
Spread’s the Word
Fed Funds target rate, US dollar 3-month Libor, and the Libor-OIS swap rate, 2008 - 2018
Source: Bloomberg, March 19, 2018. Left scale is in basis points, right scale is in percent. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
That’s why the recent rise in the swap rate is of concern; it erodes a source of bank profitability in one of its markets. But a rising swap rate is also read as a market-based tightening of the money supply, akin to the effect of a Fed rate rise.
So does that suggest that a rising Libor-OIS swap rate will affect the number of times the Fed chooses to increase rates over the next year? Only time will tell.
On the Slide: The U.S. Dollar Discount in Emerging Market Yield
One advantage of investing in local-currency EM bonds instead of their U.S. dollar equivalents has been the better yields available for U.S. dollar investors willing to absorb the currency risk by “going local”.
But that differential has closed in recent weeks, as shown in the chart below. Interestingly, the convergence has been from the dollar side. This change could be the result of market’s concluding that the recent tough talk on tariffs gripping some governments could affect the prices of EM-sourced raw materials. But that could be an opportunity rather than a threat. Over the past few years, EM economies have been moving away from dependence on the export of raw materials, and toward the export of services – especially high-margin technology services, much of which is priced un U.S. dollars or euros.
Threat, or Opportunity?
Yield-to-worst for Emerging Market Bond Indexes, US dollar and local currencies.
Source: Bloomberg, March19, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
If the convergence of yields is due to a misperception of economic reality, it very well might represent an opportunity for the discerning investor able to take advantage of that misperception.