It's Not Just the Shape

Mid Week Bond Update

It's Not Just the Shape

It’s the underlying yields, rather than the overall shape of the curve, that have been the focus in recent days for fixed income markets.


As anxieties over the path of the U.S. 10-year Treasury subside (for now), the fattening “belly” of the yield curve – the rising yields in the region between 2 and 10 years –  has focused attention on yields, which are the result of the supply and demand dynamics for the shorter side of the U.S. Treasury market.  As intermediate-term yields rise, parts of the banking sector are dusting off their marketing plans for gathering deposits via sales of CDs – seeing the possibility of improved balance-sheet profit from rising time spreads. The need to finance these CDs without incurring credit risk is turning banks into ready customers for the higher-yielding Treasuries created to finance the U.S. government’s rekindled demand for cash.

Meanwhile, as the market prices in the changes at the short end, 3-month US dollar LIBOR is pausing its upward drift as borrowing stabilizes. As a result, the LIBOR-OIS spread continued to back off from its early-April high of 59.6 basis points to 51.4 bps, reflecting the slight decrease in demand for overnight paper as the Fed’s intentions between its March and May meetings became clear.


US 3-Month LIBOR OIS Spread, 5/7/2017 - 5/7/2018

Source: Bloomberg, May 9, 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.

 

On the Rise: U.S. Dollar

Currencies are notoriously fickle, affected by geopolitics, central bank policies, interest rate differentials, and shifting opinions about all of these. Since the beginning of the year, the dollar has see-sawed against the world’s other currencies.  But on a trade-weighted basis, the greenback has climbed steadily since mid-April, rising just under 4% between April 16th and May 7, pretty much in a straight line.
 

U.S. Dollar (Trade-Weighted), 2/1/2018 - 5/8/2018

Source: Bloomberg, May 9, 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.

As usual, opinions differ as to cause.  But since that appreciation has taken place against pretty much every major currency at the same time, it’s clear that this is about the dollar itself.  The simplest single explanation might be global funds flows, as the short end of the U.S. yield curve begins to generate attractive income on an absolute basis as well as relative to others – especially in Europe.


Major Currencies Spot Price Movement, 3/30/18 - 5/8/18 (%)

Source: Bloomberg, May 9, 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.

 

The same is mostly true for EM currencies for that period, though the Argentine peso, the Russian Ruble, the Turkish Lira and the Brazilian real each had their independent reasons for falling.

Emerging Market Currencies Spot Price Movement, 3/30/18 - 5/8/18 (%)

Source: Bloomberg, May 9, 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.

 

On the Slide: Emerging Market Yield Differentials

The nearly 5% fall in the Bloomberg Barclays EM Local Currency Index since its high on January 25 of this year is well known. But perhaps more important is the decline in the yield advantage between the local-currency index and its hard-currency[i] equivalent over the past three years. For the 5-year maturity, by the end of June 2016, the differential was as high as 3.69 percentage points. Since then, it’s touched 2.03% toward the end of April, and was 2.14% as of May 8. In terms of yield-to-worst, the hard-currency index is now slightly higher than its local-currency equivalent: 4.99% vs. 4.96% as of May 7th.


Yield Differentials, EM Local Curency Sovereign vs. U.S. Treasuries, 5-Year Maturities (percentage points), 5/6/2016 - 5/6/2018

Source: Bloomberg, May 2, 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.

 

Does that erase the overall advantage of owning local-currency EM bonds? Most likely, that depends on the specific bond and country. In any event, this change could be an additional side-effect of the flow of funds to the U.S. short end.

 


[i] So-called hard-currency EM bonds represent issuance denominated in currencies such as the euro, the dollar, the Japanese yen or the British pound. The issuing company or government is obligated to pay dividends and the face value of the bond in the hard currency it borrowed.  Local-currency EM bonds are denominated in a country’s own currency.

The LIBOR-OIS spread is the difference between the London Interbank Offered Rate (LIBOR), which is the daily rate banks charge each other for loans in London and the overnight indexed swap (OIS). The OIS is derived from the overnight rate and is typically fixed by central banks.

A spread is the difference in yield between two different types of fixed income securities with similar maturities

 

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