EM Spreads: The Wider They Go

Mid Week Bond Update

EM Spreads: The Wider They Go

Emerging Market (EM) spreads are at record highs; China's bonds have risen solidly; Treasury yields have turned in their first inversion of the current cycle.

Investors in Emerging Market (EM) debt, both hard- and local-currency, have had it tough in 2018, between country-specific problems in Turkey, Brazil and Argentina, the strength of U.S. dollar, and worries about the prospect of a recession brought about by troubles with trade.

Yet these issues have also resulted in EM debt being perhaps the most undervalued asset class within fixed income according to Ken Leech, Chief Investment Officer of Western Asset. His Q4 Outlook points out that the yield of EM debt as an asset class has neared record “wides” vs. developed-market yields when both are adjusted for their respective rates of inflation (as shown below). In addition, EM currencies as a group are 35% lower than just five years ago, thanks to the strong U.S. dollar.


Chart Courtesy of Western Asset Management.  Source: Bloomberg, HSBC, as of 31 Oct 18. * Real, or inflation-adjusted yield, is the indicated yield adusted for the effects of inflation in their own markets. 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.

All this suggests that EM debt would be among the biggest beneficiaries of a reduction in any of the global risks currently preoccupying investors. That’s not a prediction that the world will shed its worries at any particular time. Rather, it suggests that the asset class appears to be priced in a worst-case scenario, which might or might not actually take place.

On the rise: China’s currency

The 1.8% rise in the yuan since November 30, from about 6.96 to 6.83 against the U.S. dollar, was believed by some observers to be precipitated by the meeting between Presidents Xi Jinping and Donald Trump at the G20 meeting in Buenos Aires over the weekend.  But other observers point to the confidence shown by the People’s Bank of China (PBoC) in neither injecting nor draining capital into the economy since the end of October.  Instead, the PBoC cut banks’ required reserve ratio by one percentage point to 14.50 percent, releasing some $175 million into the economy for possible use in additional bank lending.

Another key signal of growing confidence: the rally in China’s sovereign bonds, with the yield of the 10-year moving down some 70 basis points to 3.4%, one of the better-performing sovereign bonds this year.

On the Slide: Inversion Sighting: the 2 year - 10 year Treasury

Fans of recession signals finally got their much-anticipated inversion, as the spread between 2-year and 5-year Treasuries fell below zero – albeit by just under 1 basis point.

It is tempting to dismiss this single data point as an anomaly. But one possible trigger of recession may have been lessened, as the Fed considers the backlash from its announcement that it might bring its interest rate into a restrictive, rather than a neutral, range.  While market watchers appear to still anticipate three hikes by the Fed in 2019 after its presumed December move, the FOMC’s own forecast, to be released along with the Fed’s December 19 rate decision, could very well tell a slightly different, and more reassuring message.  In addition, the Fed’s own forecast for growth over the next two years, though not forecasting a recession, are notably lower than the 4.2% annualized growth rate recorded as of June 30, 2018.



The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Spreads refers to bonds other than Treasury securities and include securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.

“Wides“ refers to the width of the spread between the yields of two similar fixed-income securities. For example, the expression “the bonds closed at session wides” means that the spread between the two bonds was the largest (widest) it had reached during the trading session.

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.



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