Market Views: Fixed Income
EMD Relative weekly notes
Week Ending February 5, 2016
This week the accumulated weight of negative US economic data and the market’s pricing out of Fed rate hikes finally hit the US dollar, and on Wednesday the currency had its worst day in five years. While growth fears may weigh on equity investors, a weaker dollar is positive for emerging market debt investors. A continued break in the strength trend would mark a change in trend that has decimated emerging market currencies since early 2014.
The chart below shows the dollar index, the Mexican peso (purple, with a rising line indicating depreciation) and the price of oil (green, inverted). The correlation of these assets simply tells the tale for emerging markets over the past two years: the Fed’s QE withdrawal, and promise to move towards “normal” interest rates, drove the dollar sharply higher. This caused the price of oil to move in the opposite direction (with additional drivers, of course), while EM currencies represented here by the most widely traded Mexican peso went sharply lower. The negative economic data is perceived to stay the Fed’s hand in raising rates. A stay would likely help to reduce the divergence in developed monetary policy, which should give pause to the substantial number of market participants who have bet that US growth stronger than the rest of the world meant an ever-strengthening dollar and ever widening interest rate differentials. But today, growth prospects in the US seem to be about on a par with those of Europe and trending lower while Europe’s are stable. So the weight of the market getting on-side to that reality could be substantial.
Source: Bloomberg, US Dollar Index, Mexican peso (inverted), Brent crude front month contract. Past performance is no guarantee of future results.
The alternative argument is that weaker growth leaves a safe-haven bid for the dollar intact. While that is certainly a possible outcome, we would distinguish between a slower growth trajectory that leaves the Fed on hold (which is what seems to be unfolding now) and an outright recession that causes systemic stress. That thesis remains untested and would obviously require a re-calibration of a view on the softer dollar impact across asset markets. One encouraging signal so far is that in recent days the price of oil has remained near its near-term highs of about $34 while equity markets globally have remained soft, thus de-correlating from recent patterns. It would be difficult to envision that happening in a perceived stress scenario.
A somewhat softer dollar would work to put a floor under commodity prices, and spur more liquidity flows into emerging markets. Stable to somewhat appreciating currencies would curb rate hiking cycles in those countries dealing with the inflation pass-through of deeply depreciated currencies, leading to a marginally better growth outcome. So the positive cycle, even if muted this time around, is clear.
To be sure, it is early to suggest that the positive cycle is set to unfold; however a necessary but not sufficient ingredient has started to manifest.
For dollar emerging market debt, we think it’s a bit more straightforward: the weaker growth story is leading to a flatter yield curve which makes dollar spreads over treasuries that much more appealing for risk-tolerant investors. Spreads on investment grade sovereign bonds remain at around 300 basis points, so with an historical average of just over 200 basis points, substantial value remains in taking some interest rate risk on emerging market dollar debt in the context of softer US growth.