Ashmore's Jan Dehn: The last QE trade

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EM markets are now outperforming developed markets both in normal market conditions and during bouts of serious yield curve steepening in developed economies. Last week German and US long bonds dropped by 2%, while local currency bonds in Emerging Markets (EM) – a widely despised asset class on account of recent FX volatility – were down a mere 45bps. EM spot FX was down just 4bps compared to 35bps for the broad Dollar index (DXY). Being dollar-denominated, EM sovereign bonds declined more than local currency bonds, but by virtue of fat spread cushions and supportive technicals they outperformed developed market bonds. EM High Yield (HY) corporate bonds dropped a mere basis point during last week’s developed market long-bond slaughter, outperforming significantly compared to US HY which dropped 47bps on the week.

The differences between this steepening episode and past ones, such as the Taper Tantrum

In 2013, US 5y5y breakeven inflation expectations declined even as nominal bond yields increased sharply, which resulted in a dramatic rise in real bonds yields of some 200bps between late 2012 and Q3 2013. By contrast, the current sell-off in developed market bonds has almost exactly mirrored rising inflation expectations, wherefore real yields have remained low and relatively stable. As the chart below shows, US 5y5y real yields remain near the lowest levels in the last three years. Hence, inflation is hurting bonds in developed markets, but has little impact on EM.

The price action in October constitutes yet another important warning to global asset allocators about their positions in developed bond markets. German and US long bonds were up about 15% earlier this year, they dropped no less than one third of this return in just one month as German long bonds fell 5% and US long bonds were down 4.75%. Moreover, this recent bout of volatility is not the first warning. The curve also bear steepened ahead of the Fed’s September meeting and German long bonds experienced a sharp rise in yields in the spring of 2015. The Fed’s suggestion, in Q3 2015, that the USD rally poses a problem to the health of the US economy also has implications for total return expectations in Dollar bond markets.

Three reasons why investors should be worried about developed market bonds

1. Valuations are extremely stretched. Short duration bonds already trade with materially negative real yields. Now that long bond yields have also fallen investors should ask where and how they are going to realise further upside?

2. Developed bond markets are vulnerable, because the US economy is clearly experiencing inflation. While core Personal Consumption Expenditure (PCE) inflation – the Fed’s preferred inflation gauge – is only rising at a pace of 1.7% yoy the low inflation reading in the PCE index mainly reflects that medical expenses, i.e. medicine and medical services, are recorded in the index at subsidised Medicare prices, not market prices. The core CPI index, which measures medical expenses at market prices, is already at 2.3% yoy, which is well above the Fed’s 2% yoy inflation target. This means that the Fed is basically clinging to administered prices in order to sustain the pleasant fiction that inflation is not a problem. Clearly, if the market was to take the Fed to task over inflation – which is inevitable at some point – long bond yields could rise much, much higher.

3. The technical demand from the QE central banks for bonds is waning. QE purchases have been the overwhelming driving force behind the fixed income rally in rich countries since the Developed Market Crisis of 2008/2009. QE purchases are waning for numerous reasons. In the US the Fed was forced to taper, because far too much money was chasing assets in the US, which was causing bubbles and pushing the USD towards overvaluation. In Europe, the ECB is now considering tapering as well, because it is running out of bonds to buy, not because it wants to tighten policy. As QE bids fade so will the upwards momentum in developed market fixed income, which in turn will force investors to face the fact that the bonds have little value beyond the momentum created by the central banks.

How bad could the developed market bond rout get?

Undoubtedly, there is a great deal of profit-taking involved in the steepening episodes this year. Positions are already being squared ahead of year-end and the next Fed hike in December is a convenient pre-text for reducing exposure. There are other compelling fundamental reasons for believing that the bear steepening in developed bond markets will not go too far.

Developed economies are almost universally over-indebted with declining productivity and slow growth rates, while their asset prices are extremely overvalued after years of QE stimulus. In the US the Dollar is about 20% over valued in real terms. Under these conditions a large and sustained rise in real long bond yields would wreak havoc on developed economies and markets alike, which is something that governments and central banks will probably not countenance for very long.

The big question, then, is what the governments and central banks can or would do if and when markets suddenly got serious about dumping long bonds. Look to Japan, which is already way ahead of the curve in preparing for this eventuality. Japan knows that the economy could be sunk outright by a sudden rise in long yields, so they have simply killed off the bond market by adopting direct yield curve targeting. By committing to keeping the 10 year yield at zero the Bank of Japan has ensured that the long end of the curve remains well-anchored regardless of what happens with Japanese fiscal policy, global inflation and the US yield curve. The BoJ is sending a very clear signal that they are now in charge of the entire yield curve, which allows markets to focus on FX and stocks instead. We expect other QE central banks gradually to move in the same direction over time.

These are the reasons why it is, in our view, inadvisable to invest in developed market bonds today: there is no yield and significant capital gains are only possible in the event of a recession. On the other hand, if inflation increases it is likely that the market will not be allowed to push up yields to compensate. Instead, the market will simply be killed off’

In this environment, what should investors do?

The first step is to face reality. The developed economies rally in long bonds earlier this year was the second-last QE trade, i.e. the trade wherein investors extended duration to the very maximum in order to squeeze out the very last juice from the QE trades. Unfortunately, it may prove difficult to get out of these trades. Since a major bloodbath in duration would damage developed economies and their markets so much it would most likely not be allowed to happen. Much of the money in these markets is already locked in by new regulation and financial repression. More could be forced to stay.

This means that the final QE trade – taking profits on positions in the QE markets and rotating exposure into the non-QE trades – may have to be expressed in stocks and currencies rather than bonds. The non-QE markets are today both safer and more rewarding places to invest. At USD 18.5trn, or 20% of the world’s outstanding bonds, the EM fixed income markets make up a significant part of the non-QE universe. EM currencies and stocks are extremely cheap after years of distortions caused by QE central banks. EM countries have demonstrated strong fundamental resilience over the last few years by surviving four extremely violent external shocks in the shape of the Taper Tantrum, the start of the Fed hiking cycle, a dramatic Dollar rally and the collapse in commodity prices. Despite the headwinds, the EM growth premium never fell below 2%, while defaults, balance of payment crises and IMF emergency assistance programmes remained few and idiosyncratic throughout. The EM growth premium is now picking up. Relative and absolute valuations strongly favour EM, while positioning remains extremely supportive. This is why the attraction of EM today is that it offers both greater return and less risk than anything on offer in developed economies.

Jan Dehn, head of research at Ashmore