Yield compression

In the past days when my productivity is low, I was thinking about some global issue. Thanks to the global liquidity, the current situation is that emerging markets are in general is doing great. Yield differential across the globe has compressed to historical low level. Buying a Peru or Philippines local bond is more or less the same as buying a comparable US treasury bill. To look at a summary comparison, I pulled out some random number of local bonds: Colombia 2010: 9.2%, Indonesia 2010: 9.97%, Peru 2010: 5.6, Philippines 2010: 5.6%, Thailand: 2010: 4.45%, and finally US treasury: about 5%.

This is a large compression. Why? There are two reasons. But have conflicting implications. The first reason is investors now believe that investing in $ asset is not safe. Current account deficit, fiscal deficit, over-relying on consumption, weak export and housing bubble. Lots of indicators suggest the only support relies on the strong labor market, and business investment. There are recently some signs of weakening business investment. The fundamental points to the weakening of the weakening of the US market, either soft or hard landing. One the other side of the globe, emerging countries takes advantage of the global saving to invest into the US treasury bills, commodity resources, and fixing/restructuring their own balance sheet. Macroeconomic policies are now in place in most of the countries. In some sense, it is a good bet that the emerging countries will not face a massive crisis as we observed in the 1990s.

Under this situation, putting money into the emerging markets is a good investment, both as a hedging the moderation of the US, and take advantage of the EM growth dynamics. Yield differential is compressed as a result.

The second reason for this yield compression is the investors made mistakes. Investors with too much cash in hand has no where to invest. As a result, their risk appetite rose, and look for the high yield bond without fully taking into account its bond and currency volatility. This becomes a herding behavior or more precisely a bubble, that as everyone else believes the rest of the investors will continue the process, bandwagon effect continue until there is a trigger. Before the trigger, we continue to have a good yield compression.

The trigger can start from a mini crisis like we observe in the mid 2006. One of the many emerging countries fell into trouble, and then spread to the rest of the EM world. The problem of this type is it is hard to detect in advance. We do not know exactly the linkage between/across different region. How can we realize the Russia crisis will spread to Latin America in 1998? Even worse, it is highly possible that the leverage is concentrated in a group of diversified hedge funds. Our knowledge on hedge fund institution is minimal. What we learn is that they are “sophisticated” that allow them to make a most efficient decision. But as a matter of fact, this presumption has never been verified. To be honest, we don’t know. Also because of those hedge funds, their herding behavior will cause large market volatility without much advance notice. It is like a hot potato move around from one fund to another and eventually the chain will take the toll.

So, what will be the consequence under each case. Back to the first, where investors have “rational expectation” that on average, they are correct. The fundamental/trend of US is declining, while the opposite happens in the rest of the world. Since their expectation is realized, the yield compression converges to the US asset yield. The safe heaven/US market liquidity is offset by the local currency appreciation. $ will depreciate which offset the advantage of liquidity $ market. The yield differential converges, and the risk adjusted return between the US and EM will be at equilibrium.

With this first scenario, $ depreciates, the rest of EM currencies appreciates. Export to the US drop while EM domestic demand picks up. The large EM international reserve will be in use to stimulate the domestic demand. The rebalance will switch from US domestic consumption/EM export to US export/EM domestic consumption. The safe heaven hypothesis will switch from $ to Euro, Swiss Franc, pound and Yen. Those currencies will be moving in the same direction as the major EM against the $.

The big concern under this scenario is that if US successfully switches from domestic consumption to export, it requires two components. One is $ depreciation, Two is domestic stagnation. Uncovered interest parity implies the US long term yield will rise, while the fed policy implies the yield will drop. Most likely the curve will be steeper. The impact will not be too strong in the EM curve, as money flows into the EM currencies. EM appreciation will offset the expected loss in interest differential.

The second case is a bit worrisome for me at least in the short run. If investors are miscalculated the risk of investing in the EM markets, any minor wakeup call can reversed the trend. There are a number of things are likely to happen. First, money will shift back to the safe heaven, namely, the US, Euro, etc. $ will strengthen at the expense of the EM currencies. The strengthening of $ will have adverse impact on the trade balance. The valuation effect as we mentioned many times in the past will accelerate the worsening of the current account. On the other side of the globe, gradual EM currencies depreciation will be welcomed by several countries like Brazil, China, Colombia, but too much and too fast deprecation will guarantee the central bank intervention.

Regarding to the bond yield, this miscalculating will widen the yield differential, as seen in the mid 2006. Together with their currencies depreciation, there is a potential rise in inflation which will force the central bank to raise the interest rate further.

Which case is more likely? I don’t know, but if I am asked to put a probability, I would put a higher probability on the first scenario. Why?

One: nowadays, investors are at least partially able to distinguish bad countries from good ones. A mini crisis in a bad country (for example, Venezuela) may not have a systemic effect on the rest of the region, not to mention the rest of the EM universe.

Two: most EM countries now have the capacity to buffer from external shock (change in investor’s sentiment). External debt has been declining, international reserve has been rising. Central banks have become more credible. Their balance sheets have been improved.

Three: Trade openness has been more liberated than in the past. With more open economy, exchange rate adjustment has to be smaller to accommodate a given amount of external shock. Exchange rate movement can be spread over many countries.

Four: in many EM countries, especially in Asia, the governments have capacity to increase their spending to stimulate their domestic demand to buffet the export contraction.