U.S. Treasurys vs. Asia: Who Will Wield the Yield?
With the recent increases in U.S. Treasury bond yields, some are decrying the situation as a disaster-in-the-making for Asian economies; however, we don’t subscribe to that view completely. While the levels of yields are indeed important, they’re only part of the picture; the pace at which yields change is also a critical factor. A gradual increase in the yields to 3% (the point at which we’ll cross the Rubicon, according to several commentators) wouldn’t spark a crisis for economies that have benefited from capital flows over the last few years – in effect, it would imply a further 50 basis point (bps) move higher in U.S. Treasurys from current levels, which isn’t necessarily a huge change.
The whole issue revolves around something called the “carry trade.” In its simplest form, that’s when you borrow money in a place with low interest rates, and invest that money in a place with higher interest rates in an attempt to capture the spread, or the difference between the rate levels. The worry is that with the yield differential between Treasurys and Asian government bonds diminishing, investors will abandon Asia and pile into the U.S.
There are three important aspects of the carry trade dynamics to consider: spreads (i.e., the reward for making the carry trade), volatility (which affects your ability to hold the carry trade for the targeted period of time), and fundamentals (these are the factors that underlie the places where you’re putting your money to work). We’ll look at each, in turn.
If the spread dynamic in the carry trade keeps providing a decent risk-reward opportunity, such trades would go on, provided liquidity doesn’t dry up in international markets. Here, the recent Fed action (click here for our economist Robin Anderson’s take on “the Taper”) has raised some alarm bells, but we think that Fed policy will remain accommodative even if they stop supporting Treasury markets with their monthly asset purchases. Also, as Europe gradually heals and as Japanese institutions embark on a fresh round of carry trades to ride expectations of a weak yen and extremely low domestic rates, the flow of funds is unlikely to dry up completely.
Of course, for continued positive risk-reward opportunities, the spread has to remain attractive – and that seems to be what’s happening, judging by recent market action (e.g., wider credit spreads, steeper and higher yield curves, and weaker currencies). So far in June (as of close 26 June 2013), 10-year yields are up in the key Asian carry trade markets: +84 bps to 4.4% in the Philippines, +124 bps to 7.2% in Indonesia, and +33 bps to 3.75% in Malaysia – this is relative to an increase in 10-year U.S. Treasurys of +41 bps to 2.5%. The respective currencies are weaker by -2.4%, -1.2% & -3%.
Volatility, we think, is the killer when it comes to both carry trades and leverage. Volatility can force an investor to unwind positions at short notice (invariably, that comes at the worst of times, as margin calls pick-up). Some of the latest market action was exacerbated by the recent jump in volatility, causing outflows from spread products that had enjoyed a fantastic run on the back of fairly low levels of volatility – both implied and realized – in fixed income and currency markets. The Fed’s “taper talk” spooked such leveraged/carry trades and it’s probably for the good of the market that it happened, since it’s helping flush out excess leverage from the fixed income markets (June has seen outflow of US$58 billion from bond funds). Once the excess leverage is flushed out to reasonable levels, volatility will return to normalized levels and encourage cross-border flow of capital.
The third key aspect of the carry trade dynamic is the fundamental health of the economies on the receiving end of the carry trade. This relates to growth dynamics, debt-to-GDP levels, budget deficits, and current account deficits. Most of these countries look well balanced in these terms (possibly excluding Indonesia, which has a current account deficit). If they continue to pursue structural reforms to develop sustainable growth engines for the future, there’s little reason to doubt they’ll deteriorate. No doubt though, higher domestic rates could slow growth at the margin but will also help in preventing asset bubbles, something has had been a key source of anxiety during past expansion cycles.
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