Snapshot

Could value emerge in EMD as Treasury turbulence subsides?

The rise in Treasury yields, to price in higher inflation expectations and stronger US growth prospects, have sent ructions through markets. Year to date, the US 10-year yield has near doubled from 0.91%.

Emerging market debt has been particularly affected, given that those same drivers have fed into a stronger US dollar.

So far this year, the emerging market debt local currency index (US dollar terms) is about 5% lower. The yield is back to levels not seen since last April. The aggregate spread on the hard currency index widened significantly from early-February into March, but has retraced. It remains some 30 basis points wider compared to the level of February 2020.

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Have US Treasury yields run too far, too fast?

We believe a period of relative stability at these higher yields is likely. The market is effectively expecting a US rate hike by the end of this year, and additional hikes next year, despite no sign of the Federal Reserve (Fed) deviating from its projection to raise rates in 2023 at the earliest.

At the current pace of job gains, we will get back to pre-pandemic employment levels only by April 2023. Inflation data will very likely show sharp year-over-year increases over the next few months, since the year-ago comparison is so low. The market is well braced for this and it partly accounts for the sharp rise in Treasury yields. 

Additionally, the rise in US yields and its effects have led to a modest tightening in financial conditions. The chart below shows that emerging market bond spreads rose in lock-step with the Goldman Sachs financial conditions index, which considers exchange rate, credit spreads and yields.  A modest tightening from super accommodation should curb the most aggressive expectations for future growth and inflation and provide some support to EM bond spreads.

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