Should emerging debt investors fear Fed hikes?
The US Federal Reserve (Fed) has started raising rates, raising concerns about the impact on fixed income yields. Should emerging market (EM) debt investors be concerned or could this be a buying opportunity?
In this series, based on our paper— we look at the three previous tightening cycles that have occurred over the life of this asset class to assess the potential impact of rate hikes on emerging market sovereign debt yields over the next 12 months and beyond.
In each article, we look at a key fear that drives concern about future emerging market sovereign debt yields. We then assess the legitimacy of each fear against the Fed’s three most recent rate hike cycles: 1999 to 2000, 2004 to 2006, and 2015 to 2018. Because each of these past rate hike cycles differs in duration , speed and, more importantly, the context in which the tightening took place, we investigate key differences as well as similarities that are likely to be important drivers of performance.
Let’s start. The primary fear behind concerns about future emerging market sovereign debt yields is that the sensitivity of emerging market debt to rising interest rates could hurt performance, particularly because the duration of emerging market debt is longer now than it was in previous Fed tightening cycles.
There are three main components of EM debt returns: the starting yield of the asset class; changes in emerging debt spreads; and the sensitivity of returns to changes in US Treasury yields.
With regard to the third element, the argument that higher interest rates – and therefore higher Treasury yields – will hurt emerging market debt yields is particularly relevant today, as the The duration of emerging market hard currency debt has increased over the past 20 years as sovereign issuers have successfully extended the maturity of their US dollar (USD) issuance.
When the 1999 rate hike cycle began, the duration of the asset class was only 4.57 years. It rose to 5.77 years in 2004 and 6.65 years in 2015. When the Fed raised rates from 0.25% to 0.50% in March 2022, the JP Morgan Emerging Markets Bond Index Global Diversified (EMBIGD) had a duration as high as 7.37 years. This has increased the sensitivity of the asset class to changes in US Treasury yields.
Having established that the sensitivity of emerging market debt to rising Treasury yields is higher today than in previous Fed tightening cycles, we have to ask ourselves whether this should be of concern to investors – and the answer is that there is little historical evidence to suggest that Treasury bond yields will rise significantly. once the Fed’s rate hike cycle begins.
Using the change in the 10-year Treasury bond yield as a proxy for this risk, we can see that it is not clear that the start of a Fed tightening cycle means that bond yields at higher long term will increase sharply. In some cases, the yield on 10-year Treasury bonds was actually lower a year after the initial rate hike. And after a decades-long bull market for Treasuries, the yield on 10-year Treasury bonds had remained in a range since the global financial crisis (GFC). We expect this theme to continue as the market balances concerns about both inflation and growth.
What does the data show us?
1999 to 2000: Rise in yields
First, 10-year US Treasury bond yields rose in the year following the 1999-2000 rate hike cycle.
After nine straight years of economic growth, strong domestic demand and generationally low unemployment, the 1999-2000 hikes were largely preemptive.
The rate hike cycle only lasted six months and was limited to 125 basis points of total increases (albeit from a relatively high starting point of 5.25%).
Inflation was largely contained once the rate hike cycle began, peaking at 3.80% in 2000 before falling sharply as expected in 2001. At this point, rate hikes quickly reversed.
At that time, positive real rates were the norm rather than the exception, and the yield on 10-year Treasury bonds actually rose from 5.62% to 6.28% a year later. This 66 basis point rise hurt emerging debt yields.
2004-2006: Drop in yields
In contrast, yields fell in the 12 months following the 2004-2006 rate hike cycle.
In this rate hike cycle, the Fed has sought to fight rising inflation and calm an overheated economy.
This cycle was much longer than the 1999-2000 rate hike cycle, with rates starting at 1.00% and ending exactly two years later at 5.25%.
Unlike in 1999, the Fed felt like it was lagging the curve when it started to tighten. While growth gradually slowed, inflation remained stubbornly above 3.00% throughout the tightening cycle (although it did not get out of control and in fact returned to low levels). more acceptable soon after the last rate hike).
In this case, the yield curve was already very steep when the Fed started raising rates, with the yield on 10-year US Treasuries standing at 4.65%. It was 3.98% a year later. This 67 basis point drop was a tailwind for emerging market debt yields.
2015-2018: Few changes
Then, with the 2015-2018 rate hike cycle, we saw something different: US Treasury yields changed little.
Seven years had passed since the GFC had necessitated a prolonged period of accommodative monetary policy. The decision to raise rates was supported by a more positive economic outlook (although there were dissenting voices within the Fed and therefore the so-called “gradual return to normal” depended on economic data). After a period of expansion, the Fed also announced that it would not reduce its balance sheet for a significant period.
The rate hike cycle from 2015 to 2018 was longer than the previous two but less aggressive, with rates starting at 0.25% in December 2015 and ending at 2.5% three years later.
Under these circumstances, the yield curve, which started at a steep 200 basis point slope, flattened during the rate hike cycle. A year after the first hike, the yield on 10-year US Treasuries was 2.45%, 17bps higher than at the time of the first hike.
Our verdict: no yield increase
Based on the three previous rate hike cycles, we believe there is little evidence that the yield on 10-year US Treasury bonds will rise significantly in the year following the Fed’s first hike of the cycle. current.
Similar to the 2004-2006 and 2015-2018 rate hike cycles, the curve was steep in the first hike this time around. As of this writing, the 10-year US Treasury bond yield had already adjusted higher as the market priced in a higher terminal rate from the Fed. This is already a significant move that almost entirely matches the rise in the 10-year US Treasury yield during the 1999-2000 rate hike cycle.
We acknowledge that inflation is much higher this time around, but believe it is largely due to supply-side disruptions rather than an overheated economy and strong domestic demand. Therefore, we think we could be close to the peak of inflation. A combination of positive base effects and potential solutions to supply-side disruptions could allay some current fears about where inflation and the fed funds rate might go.
We expect the yield on 10-year US Treasuries to be between around 2.8% and 3.0% a year from now, with downside risks as a more aggressive early tightening cycle shifts the narrative of inflation to concerns about slowing growth.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.