This article was originally published on 4/4/22 under Tri-Macro Research.
The way I express short positions in emerging markets and US Treasury prices is through call options on EDZ and EUM (inverted emerging market ETFs) like as well as call options on TYO and PST (ETF inverse to the price of 10-year US bonds). Positions are documented in the Tri-Macro Options Trading section.
I think this is a great macro hedged pair trade with the potential for both positions to succeed in one scenario while one or the other prevails in the other two outcomes. If both positions profit, which is where I’m leaning, it would be due to higher US yields causing a slowdown in emerging markets which the Federal Reserve is willing to look into – viewing it somewhat potentially as background noise as he focuses on US inflation. in line.
US Treasury yields rose and as a result bond prices fell, which benefited TYO and PST positions. If there is a disinflationary slowdown large enough that nominal yields fall (damaging TYO and PST), this would most likely imply a slowdown in risk aversion in emerging markets, which would help EDZ and EUM.
Rising U.S. rates are spilling over to emerging markets due to ties to the global financial system, as a significant amount (around $14 billion) of external debt is denominated in USD, meaning that as the dollar appreciates, real debt increases as a percentage change in the exchange rate. rate. Moreover, especially for countries with current account deficits and net importers, a weak currency increases the cost of imports and can push up already structurally higher inflation rates in emerging markets.
A central bank in an emerging market would seek to avoid this by raising interest rates to prop up the currency and cause carry trade money to flow into the yield spread. However, this risks weakening nominal growth and employment if the pace or resilience of the recovery in emerging markets is different from that of the United States and the Fed.
Another way US rates are linked to emerging markets is through currency boards where the local currency is pegged to the USD within a certain range or band. Hong Kong is an example. But again, the point is the same, when US rates rise, one of two things happens.
Either one, EM rates must also rise, no matter how fragile their economic recoveries are, or two, the EM currency depreciates, increasing imported inflation and compounding the problem of EM corporate debt denominated in usd. It is also possible that both occur in the sense that the market sells the currency at a faster pace due to central bank tightening at a relatively slower pace than other central banks or at a slower pace than expected by the market, or high rates cause an economy to weaken so much that it causes capital outflows.
China and Turkey lower their rates. Brazil, Russia, Mexico, Eastern European central banks and many others tightened significantly before the Fed in order to secure a rate differential and defend the currency while facing inflation high. India remained largely stable. I wrote about what I think will happen in Brazil. I don’t like the strategy of the central bank of Brazil.
According to Bloomberg:
Policymakers have added 975 basis points to borrowing costs since last March, the world’s most aggressive tightening cycle in the wake of the pandemic, to 11.75% and pledged to raise the Selic rate further to 12.75% by May.
The Brazilian Real is moderately higher (due to the central bank’s higher benchmark SELIC rate and strong markets and commodity prices), but honestly it’s not commensurate with the magnitude of the tightening . The decision to leave the central bank of Brazil was quite extreme and I don’t think it was worth it. This gives them more firepower to cut, but they also won’t want to cut rates due to currency depreciation and imported inflation. I’m not sure what I would have done, but I probably raised rates at a slightly faster pace than the Fed – enough to keep the BRL from falling too low but also not to slow growth.
It’s a difficult balancing act and symptomatic of the whole issue of emerging markets. I think Brazil’s high double-digit interest rates will weigh on the Brazilian economy, forcing the central bank to backtrack as commodity markets also weaken (Brazil depends on commodity exports) and that the Fed is going to continue to support the USD, so I think BRL buyers will end up losing. BRL buyers won’t like Brazil’s central bank rate cuts if or when it happens. I have a price target of 6.00 on USD/BRL.
I think a key point – referring to the storyline at the end of the first paragraph on the two profiting positions – is that US Treasury yields are far from outliers from an inflation perspective, which means that yields or breakevens (the inflation expectations component of nominal yields) have not risen in line with a higher CPI. With inflation around 8%, nominal returns have always been much higher. This means that an inflation situation that ends up being transitory is already priced in by the bond market and therefore there is already less of a drop in nominal yields than many would expect in a downturn. disinflationary global.
In a risky and favorable environment for emerging markets, this would probably imply a continued rise in commodities, a depreciation of the dollar and an ever-higher inflation environment. I tend to think this scenario is rather unlikely, but in this case PST and TYO would vastly outperform. As I mentioned, bond yields are firmly on the transition team, which means inflation should come down. If not, there is a lot of catching up to do for returns.
In a risk aversion environment where there is a flight to Treasuries and falling nominal yields, this would be in response to deflationary expectations and some market event that causes a large risk aversion move . Even then, in my opinion, I don’t think US Treasuries are an optimal safe haven, as yields haven’t kept pace with the CPI, as noted above, issuance is sizable and the Fed raises short-term rates. So I think we will get a combination of the two where rising US yields will negatively affect risk sentiment in emerging markets, currencies and equities.