Emerging Rates Most at Risk as U.S. Yields Reach 10-Month High

(Bloomberg) -- The reflation trade driving a sell-off in Treasuries will have investors watching to see if this results in a spike in emerging-market yields. The pace of any such yield surge carries far more weight for developing-nation bonds than the levels reached.

Bonds from Indonesia, Mexico and Malaysia are the most vulnerable to sudden surges, because they historically have fiscal and/or current-account deficits, or both, according to a Bloomberg study of 15 emerging markets. In contrast, sovereign securities from South Korea, the Czech Republic, Poland and Thailand -- all of which have open capital accounts and a relatively high dependence on trade -- were found to be the most sensitive to a gradual move higher in U.S. rates.

Note: Consistency refers to the z-score, or ratio of average moves against the standard deviation of all moves while size refers to average move versus 1 basis point move in U.S. Treasuries

Ten-year Treasury yields soared to an over 10-month high of 1.19% on Friday, rising for a seventh day, after disappointing U.S. jobs data bolstered calls for more stimulus. Robust corporate earnings have underpinned optimism that the economy would accelerate this year even should government spending face some restraints. Dovish Federal Reserve commentary that pushed back against bond tapering speculation has also mitigated against a sudden spike in U.S. rates.

Key Insights

• Emerging-market yields had a high correlation to net changes in U.S. rates as compared to percentage changes in U.S. rates. This implies that the impact of net changes in U.S. yields is likely similar even at the current, historically low levels
• The study for gradual increases was based on six episodes up until 2020, during which the 10-year Treasury yield rose by an average 77 basis points over a horizon of 156 days
• Korean bonds saw the most consistent moves in response to a gradual increase over the six scenarios, rising by an average 51 basis points versus an average 77 basis point move in the U.S. rate, a ratio of 0.66
• For low-yielders, the Thai baht, Polish zloty and the Czech koruna are overvalued relative to their historical averages, making them more susceptible to a wider emerging-market selloff
• For rapid increases, the study looked at seven episodes up until 2020, during which the U.S. 10-year yields surged by an average of 58 basis points over a mean of 52 days
• Mexican bonds were found to be the most vulnerable. The Latin American yield rose an average of 71 basis points versus in line with average, or a ratio of 1.0. The moves are also the most consistent over the scenarios, with a z-score of 2.19
• Among those more vulnerable to spikes in U.S. yields, it’s worth noting that the budget deficits of Indonesia and Malaysia widened in 2020 to at least a decade high following pandemic-relief spending. Meanwhile, Mexico refrained from large-scale stimulus
• While Indonesia and Mexico normally record current-account deficits, both are expected to see considerably smaller gaps or even a surplus for 2020 amid declines in demand for imports following the pandemic. That could potentially offer something of a buffer

Note: Marcus Wong is an EM macro strategist, who writes for Bloomberg. The observations he makes are his own and not intended as investment advice

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