Fixed Income... Treasury Time Bomb? We stress the question mark at the end of that title. However, when we look at a long term chart of the US 10 year Treasury yield, the apex of a two year triangular formation is starting to taking shape. The beginning of this apex is setting the parameters of the current 4.00% to 4.50% range, in which the yield seems firmly entrenched.
As the apex becomes more defined, and starts to narrow, so the risk of a break out in either direction grows. However, we stress that this break out may not occur for another six months. The question then is in what direction. Well, looking at the fundamentals, the odds would appear to be skewed towards the upside. As we say above, the Fed’s decision to up interest rates amidst all the devastation caused by Hurricanes Katrina and Rita is a clear signal that the US economy is still in good shape, and resilient, for now at least, to higher oil and gasoline prices. Furthermore, inflationary pressures are to the upside, underpinned not just by energy costs, but by a robust labour market, which is adding to company unit labour costs.
There does, of course, remain the risk of the US current account deficit, and the need for foreigners to continually finance the shortfall. In this respect, further revaluation of the Chinese yuan currency, which appears likely over the medium term, and perhaps short term, will put this problem very much back in the spotlight. The more the Chines authorities allow their currency to appreciate against the US dollar, the less intervention required, and therefore less money flowing into US Treasuries – so the argument goes. Remember the 12 basis points spike on July 21?
This risk does go against our current thinking somewhat though. If it did trigger a spike in Treasury yields, it would suggest a sharp depreciation of the dollar, which at this stage we think unlikely - although, as we stress, the spike in Treasury yields may not happen for some time yet.
Instead, the 10-year yield may simply adjust higher should the US tightening cycle continue well into next year, taking the Fed funds rate over the 4.25% level currently implied by the futures market for mid-2006. As the apex of the triangle narrows, so resistance moves lower. This would suggest that any move through the 4.40% level over the coming months could well send the 10-year yield up towards the 4.80% area.
That said, we do not think yields would stay that high for too long. In today’s investment climate, where yield is so hard to come by – especially in G7 – a US government backed bond paying 4.80-5.00% would be an appealing proposition. Furthermore, returning to the financing issue, the enormous wealth generation currently taking place within the major emerging economies, and the gradual opening up of pension markets in these regions, will in time see an explosion of money looking for an investment destination. Much will be directed towards local markets, but we imagine a large proportion will also end up in western assets.
This brings us on to emerging markets. Readers will know how much we like this asset class, and we see little reason to change our opinion. In fact, this point about more and more money looking for an investment destination only reinforces our view, whether it is G7 pension fund money, or fund related money generated within emerging economies themselves.
Of course, there is a risk of an EM debt correction, especially with spreads so low on an historical basis. But the risk is external in nature, and stems from a prolonged tightening cycle in the US. This will either send US Treasury yields higher, or negatively impact on the US economy – a key export destination for many emerging markets. Yet, we remain convinced that any such correction for EM would attract substantial buying from the fund community, given the solid fundamentals of the asset class and the more attractive yields on offer. Indeed, EM fundamentals are stronger than ever, with an impressive improvement across the board in economic policy, as well as huge increases in foreign exchange reserves and fiscal surpluses. Ability to pay has never been so good, and, in fact, in a few years or less EM as a whole will become a net creditor.
However, the EM debt market as a whole, which covers local and corporate debt is set to explode, as countries converge closer to western markets. This will not be due to EM sovereigns issuing more dollar denominated debt, but due to sovereigns, banks and companies issuing in local currency. The growth potential is simply staggering, and the pension funds are going to become involved sooner or later.
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