EMD Relative weekly notes
Week Ending August 12, 2016
The Search for Yield and Local Currency EMD
Following the much stronger-than-expected US jobs report last week, the dollar has been very well behaved from the context of an emerging markets local currency investor—in fact, the dollar index as we write is almost exactly where it was just prior to the release of this number. Meanwhile, the two-year US Treasury bond is about four basis points higher, nudging up Fed rate-hiking probabilities, but only very modestly. Essentially, the market seems to be delivering the message that a further rate hike will be tough to accomplish absent a much extended run of strong data.
All of this bodes well for EM fixed income investors, especially in the local currency arena, and the local currency index is up over 2% in the past two weeks of trading. While the dollar remains determinative overall, yields are also exerting a positive influence as the global search for income shows signs of leaping from dollar-denominated EM to local currency EM. Higher yielding currencies have out-performed, and the index overall still offers significant value, in our view. The chart below shows that we are at a particularly attractive juncture in the spread between local and dollar EM. If history is any guide, we expect that this spread could narrow fairly dramatically.
Source: Bloomberg; data as of August 10, 2016. Past performance is no guarantee of future trends and results.
The global appetite for risk is obviously a key supporting factor. As long as global growth remains very low and global central banks continue to do more of the same in attempting to revive that growth, higher yielding assets like EM local and dollar bonds should do well, in our opinion.
One under-appreciated driver, we believe, is the migration of central bank policy from a reliance on negative interest rates to asset purchases, as we saw most recently in the last Bank of England meeting. Abandoning the former has taken the steam out of the strong dollar trade convincingly since interest rate differentials should no longer be forced wider, and asset purchases simply crush yields in developed markets – which leaves EM looking that much more attractive from a yield perspective.
It is difficult to see this trend changing anytime soon. Perhaps the next step is fiscal stimulus, but the necessity for political coordination makes that a long-term and well-signaled policy shift that seems well in the future. In the meantime, we still think emerging markets are consistently attractive—both local and dollar-denominated—as developed yields collapse.