Emerging Markets: sugar highs

Mid-Week Bond Update

Emerging Markets: sugar highs

Global bond markets rallied for a second week as investors sought traditional refuges following a poor US jobs report, diplomatic spats in the Middle East, further White House tensions and uncertainty around this week’s UK general election and European Central Bank meeting. The US dollar sank...

lifting Emerging Market (EM) currencies, especially the Mexican peso, which was also buoyed by prospects of a sugar deal between the two countries. Officials said an accord on refined and raw sugar exports from Mexico to the US could come within days, signalling better ties between the two countries. The peso reached 18.2 units per US dollar, its strongest level since August last year and more than offsetting its post-US election loss, partially fuelled by president Trump’s promises to build a wall between the two countries. Traditional safe-havens rose, including the yen and long-maturity US Treasuries, which became 5-day winners for a second straight week. The yield of the 10-year Treasury note plunged to 2.1%, down from 2.41% less than one month ago.

Friday’s dismal US jobs data helped drag down inflation expectations to election-day levels, erasing their sharp increase since president Trump’s victory. The US dollar fell to its lowest level since October as hopes of fast economic growth faded and market-implied expectations of future rate hikes weakened. Oil sank to US$46 per barrel, down from $51.5 two weeks ago, on the back of rising US inventories. The British pound held its level against the euro despite polls suggesting the leading difference between Theresa May’s ruling Conservatives and rival Labour party was narrowing ahead of Thursday’s election. Markets expect a sweeping May victory would give her an upper hand in the forthcoming Brexit negotiations. Click here to read Brandywine Global’s blog about this crucial election.

 

ON THE RISE

Emerging Markets – decouple from oil, trouble: EM local sovereign bonds rallied even when oil prices fell and safe-havens rose – both events which traditionally hit the asset class. This time was different, though: local bonds of oil-exporting Mexico and Brazil have posted gains over the past five trading days, boosted by political stability and a 100-basis point rate cut to 10.25%, respectively. These moves signal investors see the asset class more on the basis of its own fundamentals rather than as a proxy for other trades, such as oil or general risk mode. China, a significant buyer of some EM exports, also posted encouraging news, with its most recent foreign reserves and Purchasing Managers’ Index (PMI) figures both beating expectations. As seen on the chart, the asset class has more than offset its post-US election losses. So far this year, Latin American and Eastern European local sovereign bonds have rallied 12% and 10%, respectively, on the back of improving fundamentals and in Europe’s case, its proximity to the fast-recovering European block. Click here to read why Western Asset believes that local EM debt offers opportunity.

 

EMs shrug off post-US election gloom

Source: Bloomberg as of 7 June 2017. JPM GBI is JP Morgan Global Bond Index; USD is US dollar; curr is currency.. RHS is right hand side. Past performance is no guarantee of future results. Please find definitions in the disclaimer. 

 

European banks – banking it: The premium that investors pay to protect themselves from European banking sector default risk has this year fallen more than for other industries, a sign of improved confidence in the asset class. After years of government rescues and balance sheets inflated by non-performing loans (NPLs), European banks are now benefiting from an improving economy and general better health: credit fundamentals have improved, capital has been raised, NPL portfolios, sold, and cost cuts, made. Investors also expect the European Central Bank to start tapering its monetary stimulus in the near future, something which could lift rates, helping banks improve their profit margins.

 

ON THE SLIDE

US rate expectations: second thoughts:  Market-implied expectations of future interest rate rises are fading as promises of faster economic growth are questioned and data points towards a slow growth pattern. US May payrolls’ increase of 138,000 came in again substantially below expectations, leading to a drop in Treasury yields as well as in inflation expectations. The difference between the 10 year nominal Treasury yield and its inflation-adjusted equal has now fallen to 1.7%, its lowest level since Trump won the election in November. Although markets are still expecting a rate hike in June, investors are diverging again from the Federal Reserve in their longer term projections. As seen on the chart, while the market-traded Fed funds futures indicate rates will be at 1.5% and 1.7% in 2018 and 2019, respectively, the monetary authority sees them substantially higher, at 2.1% and 3%. According to Western Asset’s Chief Investment Officer Ken Leech, US Treasury yields have fallen back to low levels, perhaps reflecting a too pessimistic scenario. This drop, however, has increased the relative attractiveness of spread sectors, especially outside the US.

 

The Fed vs the market: mind the gap

Market-implied rate expectations plunge as data disappoints

Source: Bloomberg as of 7 June 2017. Fed is Federal Reserve; bps is basis points. Past performance is no guarantee of future results. Please find definitions in the disclaimer. 

 

Pound – UK budget deficit: different stories: The UK currency and the country’s government deficit are becoming a total mismatch. After mostly tracking each other in the years before and shortly after the 2007/2008 financial crisis, they have not only stopped moving in tandem but also seem to behave totally differently: from 2013, the country’s budget deficit has steadily improved from 7% to 2.48%, mostly through the cost-cutting efforts of a conservative government. Sterling, however, failed to match such improvement, and even started to drop in 2016, plunging after the country decided to leave the European Union in June. While a falling deficit has been positive for gilt yields, the currency story reflects another, less shiny Britain.

 

Source for all data: Bloomberg and Barclays Capital as of 7 June 2017, unless indicated.

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