International Bond Volatility and Feral Hogs
Foreign and domestic fixed income markets have reacted strongly to the prospect of U.S. Federal Reserve tapering. Interest rates have increased in most developed markets, and 10-year U.S. Treasury rates rose from 1.62% on May 2nd to 2.59% on June 24. The strong reaction across markets prompted Richard Fisher, president of the Dallas Federal Reserve, to liken big money to “feral hogs” in a June 25 interview with the Financial Times, saying, “If they detect a weakness or a bad scent, they’ll go after it.”
Indeed, the reaction in emerging market debt (EMD) has surprised many, as rates in places like Mexico, Brazil, Russia and elsewhere have risen faster than in the U.S. It now appears that the outsized reaction in foreign debt markets may have started with the unwinding of momentum trades by commodity trading advisors (CTAs) and hedge funds.
Such a series of “liquidation events” is not based on fundamentals, in our view, but is very much an unwinding of so-called “carry trades.” Many carry trades were leveraged or expressed in derivatives markets — especially the swaps market, which witnessed a stronger sell-off than the underlying cash bond markets did.
Nevertheless, liquidity in EMD has been hampered by the selling pressure. Spikes in market volatility can be difficult to stomach, though such “value creation” events do seem to be more common in the world since 2008. The impact on international bonds has been acute given the double whammy of rising rates and a rising U.S. dollar.
While we continue to believe that the U.S. dollar is likely to remain relatively strong in the near term, the spike in EMD yields is less justified, in our view. To the extent that fast money has pushed the less liquid EMD — and domestic high yield bonds, for that matter — around in this “duration aversion shock,” we believe fundamentals may reassert themselves as 2013 progresses, and we believe EMD prices may potentially recover partially.
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RPL0000.162.0713 July 8, 2013