What are the implications of surging global long-term yields for emerging markets? What are the cyclical and structural factors driving the sharp repricing in rates to the highest levels in over a decade? Could the jump in yields and heightened volatility become a risk to financial stability? And what is the future path for rates, the dollar, and asset prices more broadly? These were some of the questions that TRG’s macro analysts and portfolio managers tackled in the latest global strategy meeting (“GSM”).
The ongoing global bond turmoil is emblematic of a market that is lacking a clear narrative, leaving GSM participants cautious and echoing the tone from September’s discussion. Last month’s sharp selloff is creating some pockets of value; however, high uncertainty over potential near-term catalysts to anchor interest rates means markets are likely to remain choppy.
Growth, inflation and the Fed
The main development of the past month was the relentless rise in long-term global yields. An overview of potential drivers of the move kicked off the discussion – a necessary step to try to understand the future path – starting with outlooks for growth, inflation, and interaction with monetary policy. The broad U.S. macro configuration of solid growth prospects and gradual disinflation remains intact. Labor markets remain strong, consumer spending is resilient, and there are tentative signs of a manufacturing inflection.
Inflation data, such as the lower-than-expected August core personal consumption expenditure (“PCE“) deflator, keeps pointing in the direction of moderating pressures. Long-term rates, however, are ignoring the benign inflation developments and are climbing on the back of upbeat growth news instead. The bulk of the near one percentage point upward shift in back-end rates since mid-year, indeed, came from real rates, while inflation break-evens have been steady (see Figure 1). That supports the view that the expectation for resilient future growth, rather than fears over higher inflation, is the dominant driver. The last half point or so in the uptrend in real rates, moreover, followed the U.S. Federal Reserve’s (the “Fed”) September 20th “hawkish hold”, so part of the adjustment may be the market digesting policymakers’ higher-for-longer message, too. Indeed, ratecut expectations for 2024 saw a sharp repricing to just three quarter-point moves as of early October from nearly six as of midyear. Some speakers contended that good growth figures would prevent the Fed from turning dovish, even if there is additional progress with disinflation – and that this tension would prevent rates markets from settling.
Rates: higher for much longer?
The relentless bear-steepening of the yield curve since late September has been a key feature of the recent market action. That observation morphed into a discussion about rising term premia – the additional compensation that markets are demanding for holding long-dated debt
(see Figure 2). The shift in term premia, speakers argued, suggests that greater uncertainty and a possible rethink of some structural factors could also be playing a role in the long-end selloff. One element is the worsening supply demand imbalance brought about by the ballooning U.S. fiscal deficit and associated larger auction sizes of long dated paper; ongoing quantitative tightening is probably adding pressure too, even though neither of these two trends – the shrinking of the Fed’s balance sheet and fiscal deterioration – are new. Some speakers also flagged dwindling foreign demand and concerns over the fiscal consequences of U.S. political polarization as sources of noise. Last, portfolio managers stressed the importance of technical: surveys and other metrics indicated investors were long duration on expectations of a Fed pivot, and the unwinding of those positions magnified the selloff.
Recent interest-rate volatility aside, macro analysts disputed that from a long-term perspective there are fundamental reasons supporting the narrative that the cost of capital will stay higher than in the past. Specifically, markets are transitioning to a backdrop of deglobalization, financial fragmentation, rising costs from the green transition, mounting fiscal pressures from aging, the end of the peace dividend, and a potential artificial intelligence-driven productivity boost. Combined, we believe these shifts point to greater growth, inflation, and policy uncertainty ahead.
Markets and emerging markets implications
The cautious tone from the September GSM discussions carried into October as markets keep struggling with the many crosscurrents that sparked a long-term Treasury yield selloff, pushed the dollar stronger, and pressured stocks lower. Correlations between stock and bond returns moved further into positive territory, a dynamic reminiscent of the difficult 2022 investment backdrop. Emerging markets were not immune to the U.S.-centric jitters, with the main stock and bond indices giving back most of their 2023 gains. Portfolio managers debated that a drop in volatility in U.S. long rates – and not necessarily lower yields – could act as a catalyst for emerging market assets to regain ground. This could also unlock the value created in countries and companies with stronger fundamentals that were also caught in the broad-based selloff.
Technical factors hinted that the bearish momentum in rates may be approaching a point of exhaustion, but a clear shift in growth data was likely required to anchor rates on a more sustainable basis. Incoming U.S. activity figures have been softer at the margin and consensus projections see slower growth this quarter and next; however, speakers thought they were not sufficiently weak to alter the favorable growth picture. And we believe that means the Fed won’t find the space to signal that the tightening cycle is over. Another signpost comes from relatively tight credit spreads, which reflect the market’s view that higher real yields are not about to cause a hard landing or some accident. Regarding the U.S. dollar, it is likely to remain supported by the combination of greater uncertainty and U.S. growth outperformance relative to China and Europe where economic news keeps surprising to the downside.
