Fixed Income

EMD Relative weekly notes

Week Ending September 29, 2017

10/02/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

This month will end almost certainly  with a negative return for the EMD local currency index (as represented by the JP Morgan GBI-EM Global Diversified Index) and possibly for the dollar sovereign index (as represented by the JP Morgan EMBI Global Diversified Index) as well.  For local currency that ends a string of nine consecutive months in the black.  Two events conspired in September: US Federal Reserve (Fed) chair Yellen suggesting in a speech that December was close to a lock for a rate hike, and tax reform talk gaining momentum in Washington.  The dollar and treasury yields both rose. 

Prudent EMD investors with a sense of history should recognize the need for caution in the face of those macro drivers.  Yet the market appears unconvinced that either event will materialize.  The market reaction thus far in the dollar and treasury yields has been a fraction of the reaction post-Trump election and the famous (or infamous) "reflation" trade.  It’s nearly impossible to reasonably come up with probabilities for a tax reform package first, and the potential market reaction later. 

For the Fed, we think there is a rough roadmap available.  This year the Fed has hiked in mid-March and early June.  Each time the market has been skeptical of the Fed's hiking intention, then moved to swiftly price it in following a Fed signal, followed finally by expressing some skepticism for further hikes.  Should December be any different?  Only if one sees inflation or growth rising meaningfully in the US and there continues to be scant evidence of either.

This matters much for EMD investors and the chart below shows why.  It displays the movement of the two-year US treasury as a proxy for rate hike probabilities, and the currency component of the local currency index (inverted). If the market believed that the Fed was embarking on a series of rate hikes it seems likely that the two-year would not have re-traced its upward yield path after pricing in 100% of the current hike.  Neither the current data mix nor the market's attitude toward prospects for tax cuts suggests December should be different.

Source: Bloomberg, JP Morgan, US Generic Govt 2 Year Yield (white, LHS) and JP Morgan GBI-EM Global Diversified FX Return (orange, LHS); data as of September 29, 2017. Performamce shown reflects past performance which is no guarantee of future results.

If true, we think the EM currencies seem to have priced in efficiently the greater December hiking odds after this week. But it is not likely fully priced, with market odds of just under 70%. So if current year history is any guide, some weakness remains likely in the very near term, we feel, but a rally post the perfect pricing of a December hike would follow. Thus we find it hard to feel that this week marks a sea of change in EMD prospects, and if currencies hold up, we believe that a blended portfolio of the entire EMD opportunity set may continue to perform quite well versus the global fixed income universe.

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.