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Fixed income
03 Oct 2019 | By Huw Davies

The DM/EMD Conundrum: You pays your money and you takes your choice

Anyone who’s been watching financial markets over the course of the last few months will have been aware of the huge rally in developed market yields over that period.

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Anyone who’s been watching financial markets over the course of the last few months will have been aware of the huge rally in developed market yields over that period. This has been driven by concerns over the global economy, the US-China trade war, Brexit, weak economic growth, and Trump tweets; seemingly a perfect storm of worrying news from around the globe.

However, in my opinion the most extraordinary move has been in long-dated forward rates. These rates are usually relatively stable as they discount investors’ long term expectations for the global economy and look through the short-term political storms such as Trump’s presidency and Brexit.

10yr10yr forward rates (what the market is discounting 10-year yields will be in 10 years’ time) have collapsed to unprecedented levels:

Source: Bloomberg as at 01/10/19

These 10y10y rates have touched new all-time lows over the last few weeks and the big question now is whether the developed markets of the world are entering a new economic period, one described at length by the American economist Larry Summers as “secular stagnation”.

Enduring Summers

The theory doesn’t come from Larry Summers himself, as he readily admits, but is rather a revised economic theory first proposed by the Harvard economist Alvin Hansen in 1938, after the devastation of the Great Depression. His theory put forward the idea that the US economy was suffering from a lack of investment opportunities due to diminishing technological innovation, an ageing population and too little immigration.

The economic theory was largely discredited due to the enormous economic boost given to the US by the demand for military goods driven by World War II, the post-war baby boom and the technological advances in the 1950s and ’60s, again probably driven by the innovation of the war years. The question is whether the theory was valid but was simply overtaken by the enormous impact of a global conflict?

Larry Summers revisited it in 2013 in the aftermath of the Great Recession, predicting that real interest rates would stay close to zero and likely remain in negative territory driven by ageing populations, a fading pace of technological innovation and chronically low productivity in the major economies.

There is a very real possibility that Summers is right. Indeed, to a degree this has been the situation for some time in Japan, while Europe appears to have now joined the “party” and the UK and US seem to be walking up to the front door with their Watney’s Party Seven in hand (you have to be of a certain age to get that!) 

Implications all round

As far as I’m concerned, the interesting dynamic is that if Summers is right then this trend has massive implications for all asset classes as ageing investors around the globe search for yield, any sort of yield, to finance their increasing longevity.

In particular this focuses the eye on fixed income spreads and where the valuations for those asset classes are affected by these trends.

Source: Bloomberg as at 01/10/19

Emerging market (EM) spreads (above is the JP Morgan EMBI Global Diversified Blended Spread) are mid-range on a 10-year basis, it’s certainly hard to argue that they look cheap!

Over this 10-year period EM spreads are broadly the same now as they were in 2009, so an interesting question to pose would be, “is a 340 basis-point spread over a 3.25% US Treasury 10-year yield (where they were in 2009) the same as a 340 basis-point spread over a 1.75% 10-year yield (where they currently trade)?”.

An underlying assumption with any spread analysis, but seldom considered, is that there is some mean reversion over the cycle in the underlying “risk-free” asset.

If we have made a significant step into a new regime for developed market government bonds (and that’s a key question here) then the parameters for other asset classes needs to be re-examined.

If the world has changed then we need to look at different methods of analysis such as the ratio of yields between emerging market debt (EMD) and US Treasury yields. That analysis is rather revealing:

Source: Bloomberg as at 01/10/19

This chart shows the ratio of the JP Morgan EMBI Global Diversified Blended Yield to the 10-year US Treasury generic yield. It shows a very different picture. Recent levels suggest that EMD was close to the cheapest level to US Treasuries in the last decade, offering nearly 3.5x the yield available from 10-year Treasuries. In fact, a longer perspective of this analysis makes recent levels even more compelling.

Source: Bloomberg as at 01/10/19

Whatever your view of the world, the current level poses a question that demands an answer; have developed market bond yields rallied far too far or are EMD yields cheap? In my view they can’t both be right.

Investors should sell DM government yields or buy EMD. We have already touched “crisis” levels for this ratio; you pays your money and you takes your choice!