Fixed Income

EMD Relative weekly notes

Week Ending July 27, 2018

07/30/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The chart below shows a comparison of two periods of a sharply rising US dollar and its impact on EMD sovereign spreads to US treasuries. The two periods are: 1) the low in spread–to-treasuries for this year's episode which began in April, and 2) the June 2014-January 2016 period.

Source: Bloomberg, as of July 27, 2018. JPMorgan EMBI Global spreads to 10-year US treasuries. Yields and spreads fluctuate over time.

Immediately noticeable is both that the current period had a much sharper rise at its beginning than in 2014, and that there has been a significant rally back, which has tightened spreads about 35 basis points from their near-term wides.

Clearly there were periods in 2014 of a reversal, yet we wound up with a total widening of about 253 basis points at the peak. Does that mean we should expect the current episode to widen similarly, despite the EMD rally this month? While we are humble about our ability to forecast the future; for now we think the answer is no.

The difference this time is events in China. In 2014, the CNY depreciated as a result of US dollar strength but it was accompanied by capital outflows that caused global markets to shudder. This time around the CNY depreciation from mid-June to today has been 6.8%, yet EM has ralled. This depreciation is associated with a general monetary easing to help growth, and markets have accepted it benignly—the Shanghai stock market is actually up month to date, suggesting equity inflows.

While US growth was strong in the second quarter, most economists believe, and the currently declining Citi economic surprise index seems to confirm, that growth will be slower going forward. We think that should continue to keep the odds of another sharp USD rise relatively lower, suggesting the China depreciation will continue to be seen as wise policy rather than a forced response like 2014.

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.