Fidelity and Aberdeen Say Beware Next Leg of Treasury Rout

Emerging-market investors are taking the Treasury selloff in their stride, but if the reflation trade comes for shorter-dated U.S. bonds, the real pain may be yet to come.

Bets on faster economic growth are shaking up the world’s largest debt market at the long end. Now, Fidelity International and Aberdeen Standard Investments are keeping a wary eye on notes up to three years to maturity, whose yields along with the 10-year have yet to break out to multi-year highs.

A deepening rout at this point of the curve would signal a faster-than-expected pace of monetary tightening ahead and increase the competition for global capital, the thinking goes. All that has the potential to turn an orderly selloff in developing-country assets into something far more disruptive.

“A bigger problem is if the front-end of the U.S. Treasury curve starts to go,” said Edwin Gutierrez, head of emerging-market sovereign debt at Aberdeen Standard Investments in London. “The fact that it has remained anchored has meant that EM FX has been relatively resilient compared to EM credit markets.”

Fidelity and Aberdeen Say Beware Next Leg of Treasury Rout

Mizuho International Plc meanwhile sees a 0.75% rate on the five year as the tipping point for tighter international financial conditions, compared to around 0.7% currently. The yield on two-year Treasuries hit a record low below 0.1% two weeks ago amid an abundance of liquidity and remains near historic lows.

Vulnerability Concerns

With Federal Reserve Chairman Jerome Powell’s soothing pronouncements this week that the central bank is nowhere close to pulling back on its support, strategists and investors remain bullish on risk.

But concern has been building in recent weeks on the vulnerability of the historically volatile asset class to moves in the world’s benchmark bonds. Developing-nation currencies were feeling the pain of higher U.S. yields Thursday as the South African rand, Mexican peso and Turkish lira led declines.

Fidelity and Aberdeen Say Beware Next Leg of Treasury Rout

“If the U.S. Treasuries selloff is driven by the long-end and a booming reflation narrative, it would be more benign for markets than a front-end driven selloff -- which signals a growing potential for Federal Reserve interest-rate rises,” said Paul Greer, at Fidelity International, which manages about $700 billion.

The money manager has been reducing exposure to bonds most sensitive to interest-rate risk from Treasuries to emerging markets over the last three to four months.

Long-End Pain

Longer-dated Treasuries are feeling the brunt from rising inflation expectations as fresh stimulus beckons and vaccine optimism growths -- widening the gap between five- and 30-year yields to the most since August 2014. Traders have also been bringing forward expectations for U.S. rate hikes to as early as the second quarter 2023, from early 2024 at the beginning February.

All that is helping to push emerging-market dollar securities toward their worst monthly performance since September, while local bonds are headed for their worst performance since the March crash.

The speed and the nature of the Treasury selloff will determine what’s next. When the U.S. 10-year yield rose to 3.2% in November 2018 from about 1.4% in July 2016, developing-nation debt still handed returns of as high as 3.8%, powered by the global economic upturn.

Today, the 10-year yield near 1.45% still remains not far off decade lows. If it rises by around 50 basis points over the next two weeks, “markets would clearly be in trouble,” Fidelity’s Greer said. “If that same move played out gradually over the next six months it would be more manageable.”

Morgan Stanley Says EM May Avert Replay of 2013 Taper Tantrum

‘Orderly or Disorderly’

Some money managers have already positioned for higher U.S. yields, favoring high-yield or frontier bonds over lower-yielding investment-grade securities.

Emerging-market bond funds posted their first outflow since late September in the week ended Feb. 17, according to EPFR Global. About $317 million were pulled from those funds during that period, Goldman Sachs Asset Management said in a report. Local-currency funds saw inflows of $484 million though, according to the firm.

“The key to whether the market can adjust to a rising rate environment is whether the rise is orderly or disorderly,” said Todd Schubert, head of fixed-income research at Bank of Singapore Ltd. “The key for the Fed is to make sure that the slow rise higher does not get out of hand and the 1.5% level in the 10-year is a key psychological level to watch in the short-run.”

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