September 26, 2016 / 7:26 AM / 2 years ago

RPT-INVESTMENT FOCUS-Emerging markets better placed than 2013 to weather yield curve shift

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By Sujata Rao

LONDON, Sept 23 (Reuters) - A spike in long-dated U.S., Japanese and German borrowing costs has rekindled memories of the 2013 “taper tantrum” for emerging markets, even though they appear far less vulnerable than during past such episodes.

The gap between two- and 10-year bond yields in the so-called G3 countries widened sharply earlier this month - in Japan’s case to the most in seven months - on signs central banks are becoming reluctant to extend the unorthodox stimulus policies they have deployed for years.

From Sept. 8 to 15, the U.S. two- to 10-year yield spread spiked around 20 basis points, while 10-year Bund yields rose above zero for the first time since June.

This curve steepening - when longer-maturity yields rise more than those on short-dated debt - has mostly abated. U.S. rate rises are expected to be slow and gradual, and Japan’s vow to steepen its curve by putting a floor under 10-year yields has so far left markets unfazed.

But as the view spreads that central banks are reaching the limits of negative interest rates and money-printing, some are drawing parallels with May 2013, when the Federal Reserve hinted it could unwind its money-printing programme, sparking a huge selloff nicknamed the “taper tantrum”.

The U.S. yield curve steepened by more than 100 bps over the following months, causing an exodus from emerging markets and nearly triggering crises in the so-called “fragile five” countries most reliant on foreign capital.

Traditionally, steeper curves are seen as a good thing. A sign of improving growth and rising inflation expectations, they also benefit banks, pension funds and insurers who struggle to increase loan books and pay policyholders when long-term yields are low.

But for developing countries, the fallout is often negative. Higher U.S. yields can crowd out capital flows to riskier assets, all the more so if investors are not confident about a U.S. or global economic recovery.

“What we have seen.. has been policy-induced steepening rather than growth-driven. That tends to be much more damaging for risky assets,” said Kamakshya Trivedi, chief emerging markets macro strategist at Goldman Sachs.

The reaction in emerging markets this month has reflected that unease: Sovereign dollar bonds' average yield premium over Treasuries rose 20 bps in a week, while emerging stocks fell 5 percent.

Japanese and German bonds have less relevance for emerging markets than Treasuries but yield rises in the two countries are widely seen spilling into the U.S. Treasury market.


Nevertheless, many investors and analysts see little risk of taper tantrum-style carnage.

Yield curves are seen as unlikely to steepen sharply, while emerging markets' external funding needs have shrunk and balance of payments deficits are much narrower than in 2013.(

Since then, emerging currencies have depreciated, inflation-adjusted interest rates are higher and inflation is slowing.

As a result, the sensitivity of five-year local currency bond yields to developed market, or DM, yield moves has effectively halved since 2013, Goldman’s Trivedi estimates. Emerging yields may move just over 1 percentage point (pp) now for each pp rise in developed rates, he told clients.

“EM rates do respond to a shift in DM rates, but they should respond less than the peak in 2013 and that’s related to the improvement in EM fundamentals,” Trivedi added.

Finally, steeper bond curves benefit banks - the main channel for capital flows to the developing world - as they offer the prospect of higher interest income.

“A rally in DM banks decreases the concerns about possible disruptions in flows to EM and is supportive for EM performance,” BNP Paribas wrote.


But market sectors react differently to curve steepening.

Equities may be less vulnerable now that economic growth and company profits are recovering in emerging markets, says Michael Bolliger, head of asset allocation for emerging markets at UBS Wealth Management.

But sovereign dollar bonds which usually cluster in seven-10 year maturities and use 10-year Treasuries as a reference point, may be hit if it becomes costlier for governments to roll over maturing debt or sell new bonds.

Investors see company dollar bonds and debt in emerging currencies, with 4-5 year tenors, as better placed to withstand a spike in long U.S. yields. Yield too is key - junk-rated sovereign bonds with an average 500 bps premium over Treasuries may hold up better than high-grade with a 200 bps spread.

“When you have steepening curves you want to be in local debt and high-yield (bonds), not in investment-grade dollar credits as there you have no protection against higher U.S. yields,” said David Hauner, head of EEMEA Cross-Asset strategy at Bank of America Merrill Lynch.

Bolliger of UBS prefers short-duration, low-grade dollar bonds that offer substantial yield premia over Treasuries.

“Lower-rated bonds are a good to way to get interest rate carry, a spread differential around 300 bps...and a good way to protect against U.S. yield rises,” he added. (Additional reporting by Umesh Desai and Saikat Chatterjee in Hong Kong; Graphic by Nigel Stephenson; Editing by Hugh Lawson)

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