Fixed Income

EMD Relative weekly notes: Week Ending March 22, 2019


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Did the Fed usher in Act III?

Two weeks ago in this blog we suggested Act I of the 2019 EMD drama opened with a dramatic flourish of 5%+ Index gains but was followed in late February with the Act II interlude of quiet, but still satisfying, gains coming from yield alone rather than additional price appreciation. 

Frankly, we believed we would be in Act II for some time but the Fed's underlined dovishness this week has the potential to bring the curtain up on Act III, which features the potential for additional spread-to-US treasury compression towards the direction of February 2018 lows. Were that to occur, it would bring us from a current spread level of around 350 basis points to around 260 basis points. Such a hypothetical move might generate additional price gains on top of current index yields of more than 6%. 

For doubters of this (admittedly potential) investment thesis we offer Figure 1: a chart of how spreads compressed after Janet Yellen backed off a planned rate hike sequence in February 2016, and after Jerome Powell similarly shifted in early January of 2019. The evidence of post-Yellen suggests an Act III of more spread compression is perhaps probable without some type of reverse catalyst.

Figure 1

Source: Bloomberg. Chart depicts the JPMorgan EMBI Global Spread Index through March 21, 2019. Performance shown reflects past performance, which is no guarantee of future results. Actual results will differ from index results. 

That reverse catalyst would most likely be an entrance by the scourge of EMD, a strong US dollar. However Figure 2 shows that villain is likely to remain stage left. The convergence of the Citi surprise index between a weak US (in white) and a stronger Europe (in yellow) means US growth out-performance of the type that drove the 2018 version of the strong dollar is for now out of sight; in fact, we think the opposite may be unfolding which could leave the dollar weaker. 

Figure 2 

Source: Bloomberg. Chart depicts the US (white line) and Europe (yellow line) Citibank Economic Surprise Indexes for the period ending March 21, 2019. Performance shown reflects past performance, which is no guarantee of future results. Actual results will differ from index results.

Given the above, the probability skew of outcomes for the rest of 2019 favors a band of that centers more on investors achieving current yield-to-yield plus some spread compression. We think these two pieces of evidence should at least keep investors in their seats for what is to come, if not draw new curious onlookers into some of the still empty theater seats.

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.