Ask most any smart investor what could cause the next crisis in markets and the likely answer would be a sharp rise in borrowing costs brought on by a selloff in the bond market. But the thing about markets is that the pain usually originates in places where it’s least expected. That may be the case now with emerging markets.
The fact is, investors have had a few years now to prepare for the inevitable rise in bond yields that is currently underway. That’s seen in the record bets against US Treasuries. What hasn’t been expected is the big slump in EM, which attracted a record $315 billion in non-resident portfolio debt flows in 2017, as measured by the Institute for International Finance.
At one point on Tuesday, an MSCI index of EM currencies was down 1.07%, the most since June 2016, and bringing its decline so far this quarter to 2.83%. Losses in MSCI’s EM index of equities are almost 50% greater than the global market for stocks since January. A Bloomberg Barclays index of local-currency EM bonds is in the midst of its worst two-month slide since Donald Trump was elected US president in November 2016.
The bullish case for EM has largely centered on how officials have taken advantage of the global economic recovery to shore up their finances. Foreign-exchange reserves for the 12 largest EM economies excluding China topped $3.2 trillion for the first time in April, rising from less than $2 trillion in 2009, according to data compiled by Bloomberg. Even so, EM borrowers have also gorged on debt, much of it denominated in dollars. That’s concerning because the greenback is rising, meaning it’s getting more expensive for EM borrowers to service their debt. The IIF says total EM debt rose to $63.4 trillion last year from $21 trillion in 2007. The group says financing needs are highest for Turkey, Argentina, South Africa, Ukraine and India, while asset valuations look most stretched in Hungary, Korea, Thailand, Poland, and the Czech Republic.
The real tipping point?
There’s been so much focus in recent weeks on the rise in 10-year Treasury yields to the “psychologically important” 3% and what that would mean for global markets that barely any attention was paid to a more important number: 3.05%. Some strategists said that if 10-year yields breached that level — which was the intraday peak going back to the start of 2014 — it would be a big deal and foster more selling. Well, that’s exactly what happened on Tuesday, as yields broke through the so-called level of support and kept rising all the way to 3.09%. So, what happens now?
The top-ranked interest-rate strategists at BMO Capital Markets wrote in a research note that the next significant level is 3.21%, which was last seen in 2011. “We’ve focused on technical factors as driving this sell-off and as long as the price action paints a bearish picture” for 10-year Treasuries, “we’ll stand aside and wait for the selling pressure to subside before taking a stab at any long positions,” the strategists wrote. The market is positioned for even higher yields: Short positions in Treasuries are the second-most popular bet in financial markets behind, according to fund managers surveyed by Bank of America Merrill Lynch from May 4-10.
Financial repression is over
One of the big reasons — perhaps the only reason — the Federal Reserve cut interest rates to effectively zero in the wake of the financial crisis is because policy makers didn’t want investors parking their money in super-safe assets such as cash, where it would do the economy no good. This came to be known as financial repression, because savers were effectively penalized. Policy makers wanted that money put into stocks, bonds and other financial assets as a way to stimulate economic growth. It worked, because the economy rebounded. But now, for the first time in a decade, three-month Treasury bill rates have risen above the average dividend yield of the S&P 500 Index, according to Bloomberg News’s Sarah Ponczek.
“RIP to the ‘it’s painful to sit in cash’ narrative,” David Schawel, chief investment officer at Family Management Corp., tweeted after the crossover. The rise in bond rates is a function of the Fed’s efforts to raise its target for the federal funds rate, which has climbed to 1.75% from 0.25% in late 2015. As of Monday’s close, the S&P 500 had a dividend yield of 1.89%, almost one basis point lower than the yield on three-month bills.
Dollar bears weep
While investors who set up bets against Treasuries have reaped big gains, the same can’t be said of dollar bears. The same Bank of America Merrill Lynch survey referenced above found that “short dollar” is tied with “short US Treasuries” as the second-most crowded trade in financial markets. But instead of falling, the greenback has surged 4% in the last month as measured by the Bloomberg Dollar Spot Index, rising against all 31 major currencies tracked by Bloomberg.
At one point on Tuesday, the Bloomberg index was up 0.87%, the most since January 2017. So while many investors and strategists cite rising bond yields and the prospect for more Fed rate as the primary reason for the dollar’s recent strength, one can’t ignore the likelihood that much of the gains are coming from investors being forced to reverse their bearish bets as the greenback advanced. As recently as three weeks ago, Commodity Futures Trading Commission data show that hedge funds and other large speculators had a net 280,000 contracts outstanding betting on a decline in the dollar, the most since early 2013. Those positions have since been pared back to 140,000 contracts as of a week ago, the latest CFTC data show.
The rally in the dollar and the jump in bond yields is hitting gold pretty hard. The precious metal fell below $1,300 an ounce on Tuesday for the first time since December, dropping the most since December 2016. Gold is suffering as bond yields jump on speculation that the Fed is more inclined to keep raising interest rates. Since gold pays no yield, higher rates dim its allure. Also, since gold is traded in dollars, a strengthening greenback makes the metal more expensive to potential buyers.
“This move is all about the dollar and all about interest rates,” John Caruso, a senior market strategist at RJO Futures in Chicago, told Bloomberg News. “Gold is pricing in higher rates at the moment,” he said, adding that the metal could drop as low as $1,280 an ounce by the Fed’s next monetary policy meeting in a month. Gold extended its losses after falling below its 200-day moving average, according to Bloomberg News’s Susanne Barton. “Gold bears have gained the overall near-term technical advantage,” Jim Wyckoff, senior analyst at Kitco Metals Inc., wrote in a research note to clients.
Home Depot shares took a hit Tuesday after the company posted first-quarter sales that fell below estimates. Some pundits speculated that it was a sign of troubles in the housing market. Another, more benign theory is that the harsh winter led many consumers to put off home-improvement projects. Investors and economists will get more insight into the health of the US housing market on Wednesday when the government provides data on housing starts and permits for April.
The median estimate of economists surveyed by Bloomberg is for starts to have dropped 0.7% last month after gaining 1.9% in March. Permits probably declined 2.1%. “Demand should be supported by a tight labor market and steady pay gains,” Bloomberg Intelligence economists Carl Riccadonna and Niraj Shah wrote in a research report. “Despite recent increases, mortgage rates are still near historically low levels, and consumer confidence has been further bolstered as tax cuts aid disposable income.”
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