Fixed Income

EMD Relative weekly notes

Week Ending October 14, 2016


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

We believe the stronger US dollar is contributing to some weakness across risk assets, and emerging market debt (EMD) has been no exception. The dollar has soared 2.6% this month. As a consequence of that, the Chinese yuan (CNY) has depreciated just under 1%--and history tells us that relatively sudden moves in the CNY tend to draw the market's attention, and not in a good way (see August 2015 and January 2016). Meanwhile the S&P 500 index is down 0.64% as of this writing, and the US long bond has risen 20 basis points in yield.

While there are many posited reasons for these moves, surely the path to higher interest rates in the US bears some responsibility, and to some extent history is beginning to rhyme. In mid-October of 2015, the dollar began a 6.6% rise approaching their December rate hike. With a 64% probability of a December hike baked in, we can probably look forward to the Fed continuing to nudge the market in its current direction and, subsequently, further jitters are likely as global markets adjust to the aggressively stronger dollar.

In that context, October's 1.5% fall in the EM local currency index does not seem severe, especially with a 73 basis point fall in US treasury returns that is larger than the drop in the two major EM dollar bond indices.

Following last year's dollar rise and rate hike, a sharp CNY depreciation focused the market on global fears and the Fed very swiftly retreated from more rate hikes, causing the dollar to give up most of its gains. Of course, we have no idea whether that sequence of events or something like it will happen again, but there seems to be a natural limit to the market's tolerance for Fed hawkishness in the context of still sluggish growth, inflation, and the unanticipated consequences that follow.

Related to that theme, although the spike in long dated US treasury yields was sharp, fundamental reasons for a continued rise are lacking for the very same reasons. Even stabilization at the current levels would probably be a soothing balm to markets. Again, it would appear to us that EMD's yield advantage would continue to benefit investors in such an environment--as it did this month despite the current modest fall in returns. When EMD is viewed as a macro asset class and correlations with other asset classes are recognized in the context of similar drivers, we think investors will continue to be drawn to EMD absent a much more specific and significant fall out from current market movements.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.