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Asian Bond Watch

Policy shifts support EM debt ahead of elections
6 May 2019

The first quarter of 2019 revealed a marked change in the tone of developed central banks, with the US Federal Reserve (Fed) and the European Central Bank (ECB) both adopting a more accommodative stance. This has boosted 2019's bond market rally, suppressing yields even further and increasing the value of the global fixed income market. Emerging market debt has also extended its gains this year. However, various countries, especially across Asia, are preparing for a wave of elections in the coming months, which could potentially trigger some volatility.

Central bankers perform a policy U-turn

Central banks in the US and Europe have proved surprising, with a more downbeat-than-expected outlook. The Fed solidified its dovish policy U-turn by holding rates steady at the 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. The Federal Open Market Committee's (FOMC) "dot plots" signal only one increase could be on the cards in 2020. This is a significant downward revision from the December FOMC meeting, where the minutes suggested two rises for 2019 and a third in 2020.

The ECB added to the looser policy theme in March, pushing back 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 are not betting on a recession yet

Q2 2019 is likely to be a watershed moment for financial markets. The investor and market panic in the last quarter of 2018 has been swiftly followed by a rapid and broad capitulation by central banks. The question now is, does this reflect the elevated risk of a coordinated global slowdown (or even recession) that markets worried about, or the restart of a new reflation wave?

The behaviour in US fixed income markets provides some clues as to which way investors are leaning on this question. They began the year with near neutral returns in US Treasuries, but have rapidly chased returns in Q1 2019. Aggregate demand for US Treasuries hit 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 recession given the signal’s track record in the post-war era. However, the pattern of investor flows across different curve maturities is telling. While aggregate demand for US Treasuries was as strong as it was a year ago, demand across the curve is very different today.

Demand for Treasuries at the front end of the curve, which rose to a five-year high last quarter, has led this year’s surge. This trend stands in contrast to 2018, when demand was entirely led by appetite for the longer-dated Treasuries. Just as there was a clear desire to lengthen portfolio duration last year, so there is a desire to shorten duration today. Also of note, demand for the belly of the curve, which typically performs well during recessionary periods, has so far been relatively neutral. So investors are enthusiastically buying Treasuries. Although, they are not betting on a recession just yet, and are reluctant to add to their overweight at the long end of the curve at these yield levels.

A return to local currency EM debt markets

Long-term investors are underweight emerging market debt, but some of the threats are clearly diminishing.

The Fed’s capitulation means the 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 that 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 may 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 – this could potentially be positive for continuity in economic policies.
  • 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 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.

Attractive opportunities

Emerging market debt rallied in March, with both hard and local currency issues generating positive returns. Asian 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 change in monetary policy direction across the globe has also redirected sentiment away from higher yield expectations across developed markets. With yields at multiples of their developed peers, Asian bonds continue to offer attractive investment opportunities.

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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