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In the first quarter of 2019, developed central banks changed their tune, with both the US Federal Reserve (Fed) and the European Central Bank (ECB) adopting a more accommodative stance. This boosted 2019’s year-to-date bond market rally, suppressing yields even further and increasing the value of the global fixed income market. And while emerging market debt has also extended gains this year, various countries — especially across Asia — are preparing for a wave of elections in the coming months, potentially triggering volatility.
Central banks pull policy U-turn
The Fed and ECB have surprised onlookers with their more downbeat-than-expected outlooks, with the former solidifying its dovish policy U-turn by holding rates steady at a target range of 2.25-2.5%, scaling back its balance sheet reduction programme, and signalling a drop in its plans to hike again in 2019. Further, the Federal Open Market Committee’s (FOMC) dot plots signal only one increase could be on the cards in 2020 — a significant downward revision from the December FOMC meeting, where the minutes suggested two rises for 2019 and a third in 2020.
The ECB followed suit in March, pushing back its rate-hike plans until “at least through the end of 2019”. It also announced fresh funding for banks via a series of targeted longer-term refinancing operations.
Investors not putting their money on a recession yet
2019’s second quarter is likely to be a watershed moment for financial markets. The investor and market panic in the last quarter of 2018 was swiftly followed by a rapid and broad capitulation by central banks. The question now is: does this reflect an elevated risk of a coordinated global slowdown (or even recession) that markets feared or the start of a new reflation wave?
The behaviour in US fixed income markets provides some clues as to which way investors are leaning. They began the year with near-neutral returns in US Treasuries, but have rapidly chased returns in 1Q19, with aggregate demand for US Treasuries hitting a 12-month high at the end of March.
The brief inversion of the 3-month, 10-year yield spread has contributed towards fears of a recession given the signal’s track record in the post-World War era. However, while aggregate demand for US Treasuries is as strong as it was a year ago, demand across the curve is significantly different today.
Demand for Treasuries at the front end of the curve rose to a five-year high last quarter, leading this year’s surge and standing in stark contrast to 2018 when demand was entirely led by appetite for longer-dated Treasuries. Just as there was a distinct desire to lengthen portfolio duration last year, so there is a desire to shorten duration today. Further, demand for the belly of the curve, which typically performs well during recessionary periods, has been relatively neutral to date, demonstrating that investors are enthusiastically buying Treasuries. Investors are not betting on a recession just yet and are reluctant to add more exposure to the long end of the curve at current yield levels.
A return to local currency EM debt markets
Long-term investors are underweight emerging market debt, but a number of the threats are clearly diminishing.
The Fed’s capitulation means risks of rising US rates and a strengthening dollar are modest. On balance, news about the US-China trade war appears to be meandering to a more constructive outcome and the recovery in EM currencies means the inflation threat has turned, too. In response, even though recession risk has risen in developed markets, long-term investors continue to return to local currency debt markets. This trend is especially true in Mexico, Indonesia, and South Africa.
Upcoming elections could trigger volatility
On the political front, emerging markets have been gearing up for high-profile elections this year, which could potentially add some uncertainties to economies. Indeed, Asia will be at the epicentre of the story in the coming months:
● Thailand recently held its first general election since a military coup in 2014, with results expected in May. The current Prime Minister, pro-military leader Prayut Chan-o-cha, is expected to retain his post, which could potentially be positive for economic continuity.
● India’s general election is scheduled to take place over seven phases from 11 April to 19 May 2019. The polls currently point to the re-election of Narendra Modi’s government, which would underpin the country’s reform path and focus on accelerating growth measures.
● Indonesia’s presidential ballot took place on 17 April 2019. Although Indonesian President Joko Widodo and his ruling coalition have declared victory, the nation’s electoral commission is expected to officially announce winners on 22 May 2019.
● The Philippines will hold mid-term elections on 13 May 2019. Approval ratings for current President Rodrigo Duterte have been strong in recent months, also suggesting some element of certainty.
Emerging market debt rallied in March, with both hard and local currency issues generating positive returns. Asia hard currency and local currency bonds recorded total return of 4.9% and 3.2% respectively in Q1 2019.1
Investors have been seeking risk opportunities with a notable focus on high yield and investment grade-quality credit. The shift in monetary policies across the globe has also redirected sentiment away from higher yield expectations in developed markets. And with yields at multiples of their developed peers, Asia bonds continue to offer attractive investment opportunities.
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1 Source: Bloomberg, data as of 31 March 2019. Asian hard currency bond return was based on the return of JP Morgan Asian Credit Index. Asian local currency bond return was based on the return of Markit iBoxx ABF Pan-Asia Index.
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