EM Asia Risks: Beware High-Yield Spill-Over From UST Upheaval

Mizuho daily market insights by Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

“It is a mistake to confound strangeness with mystery.”– Sherlock Holmes, A Study in Scarlet

In a Nutshell: US bond market upheaval resulting in volatile in long-end UST yield surge alongside a steeper yield curve have disproportionately hurt lower-yielding EM Asia currencies/bonds; resulting in relative resilience in higher-yielding EM Asia currencies/bonds. But this is a transitional quirk, owing to a migration from lower-yielding assets to the ultimate “safe asset” (USTs) under no arbitrage conditions coinciding with yield-seeking in the risk asset universe benefitting higher-yielding asset. This however should not be mistaken for sustained, fundamental insulation from higher UST yields and a steeper yield curve. In fact, the real, hidden risk is that high-yield EM Asia not only eventually catch down, but could incur a sharper payback should sustained rise and steepening in the UST yield curve expose vulnerabilities from “twin deficits (lifting credit premium) and acute susceptibility to cost-push inflation (eroding real returns); especially if UST yield curve steepening hits “taper tantrum” trigger threshold of 180-200bps, which is just 40-60bps away.

EM Asia Low-Yielders Consistently Under-Perform UST Bear Steepening

Volatility from the sharp rise in long-end UST yields and the consequent steepening of the UST yield curve this year have rippled far and wide. But the impact has not been uniform. And in Asia, UST yield bear steepening appears to have hurt low-yielding EM Asia currencies worse; albeit not exclusively so (see Chart 1).

In fact, when smoothed for idiosyncratic factors (by taking baskets of lower- and higher-yielding currencies to mute currency-specific dynamic) the chronic under-performance of the lowest yielding currencies inversely proportional to the rise in long-end UST yields/steeper yield curve is consistent over various time horizons.

To be clear, a stronger USD coinciding with, if not caused by, UST yield surge tends to knock back EM Asia FX across the board. And so, it is more a question of degree of absolute under-performance. Nonetheless, the relative under-performance of low-yielding currencies such as THB and KRW against higher-yielding (and ordinarily higher volatility) currencies such as IDR and INR is counter-intuitive.

Transitional Quirk, Not Fundamental Defiance  

But this under-performance of lower-yielding EM Asia assets vis-à-vis higher-yielding counterparts is a transitional quirk of rising UST yields and should not be mistaken for a fundamental defiance of rising USTS yields by higher-yielding EM Asia assets on a sustained basis.

The remarkable narrowing in term premium for higher-yielding EM Asia bond yields (such as that of government bond curves for India and Indonesia) despite most lower-yielding EM Asia bond markets succumbing to steepening in sympathy with the UST yield curve (Chart 2) mostly reflects substantially larger buffer for higher-yielders compared to much thinner yield spreads for lower-yielders (Charts 3a & 3b). This significantly wider berth in high-yield spreads helps to mute transmission from the initially higher/steeper UST yield curve.

But be that as it may, this should not be mistaken for a case of high-yield assets being impervious. Rather it ought to be appreciated as a discontinuous process of risk re-pricing as markets simultaneously engaged in;

i) risk re-pricing for low-yielders (which have a much thinner insulation) and;
ii) yield-seeking in higher-yielding currencies to compensate for pick-up forgone in lower-yielding EM.

Lagged Risk-Adjusted Re-Pricing …  

But yield-seeking will have to square with, and subordinated by, enduring risk re-pricing ultimately; resulting in a re-alignment of yields across lower-yielding and higher-yielding EM. In which case, convergence in risk-re-pricing across the board is a matter of time; although admittedly, timing does matter.

Contrary to the efficient markets theory, there are kinks in initial price signals due to conflicting motivations of yield-seeking and no arbitrage switches; partly as markets initially assess different baskets of risk. The wider point though is that lagged as it may be, sustained rise in UST yields will spill-over to knock back higher-yielding EM currencies; once broader risk re-pricing catches up with initial yield seeking.

… Should a Steeper UST Yield Curve Expose Vulnerabilities  

Especially with the prospects of higher, “risk-free” returns from taking on duration exposure in a steeper UST yield curve is poised to sharply undermine EM assets/FX with “twin deficits” (which elevates credit risk premium) and higher inflation exposures (which erode real returns); as risk-adjusted, real returns factor into sustained risk re-pricing.

Upshot being, prospects of higher UST yields and a disproportionately steeper yield curve are setting the stage for a catch-down, if not a sharper payback, in higher yielding EM Asia currencies. Especially if 10Y-2Y spread of the UST yield curve, now already ~140bps (highest since 2015) threatens to hit “taper tantrum” trigger-type spread of 180-200bps; a mere 40-60bps away. So, there is no room for complacency, assuming a continuation of the current trend of under-performance of low-yielding EM Asia currencies. Or put another way, resilience in higher-yielding EM Asia currencies/assets out-performing lower-yielding EM Asia counterparts is a transitory quirk that is vulnerable to reversals and more in a “risk off” environment.

In Sherlock Homes’ words, there is no unsolvable mystery to high-yield out-performance on “risk off” from UST yield volatility, as the strange dynamics is on borrowed time (and space from yield spread buffer).

Credit Source: Mizuho Bank Ltd