Even as capital outflows from Asian bonds continue, and many emerging markets risk falling into the distressed category, the tide appears to be turning.
Foreign investor outflows from Asian and emerging-market bonds have been a recurrent theme this year. Over the six months to end June 2022, market participants withdrew US$50 billion from emerging-market bond funds1. Meanwhile, in June alone, they pulled over US$5 billion from Indonesian, Thai, Malaysian, South Korean, and Indian bonds2.
Yet, even as the US Federal Reserve (Fed) delivered another 75-basis point rate increase at the end of July 20223 – and signalled further hawkish hikes4 – the tide could be shifting.
One of the principal drivers of the retreat has been rising US Treasury yields. With more hikes in the pipeline, yields and outflows may increase. However, if we look at the pattern of Fed rate hikes versus the 10-year US Treasury yield, it shows that the two do not necessarily move in lockstep with each other.
For instance, the 10-year US Treasury yield hit a year-to-date high of 3.48% on 14 June 20225 – over a month before the Fed’s 75-basis point hike on 27 July. By that date, the yield had actually fallen to 2.73%, 75-basis points lower than the mid-June peak.
It is important to remember that the Federal funds rate is just one of many factors influencing Treasury yields. The market also prices in other aspects, such as recessionary risks, inflation expectations, and the size of the Fed’s balance sheet. Slowing US economic growth, lower inflation expectations, plus balance-sheet tightening all support the case for Treasury yields having peaked – regardless of the continued rate hikes.
Just as Treasury yields do not necessarily move in sync with the Federal funds rate, so it is with the strength of the US dollar. “King dollar” has been a pervasive theme this year, putting pressure on other central banks to hike their own rates to keep up – or risk importing inflation.
A glance at the Dollar Strength Index shows that it peaked on 15 July 20226 – weeks before the Fed raised rates. Notably, many Asian currencies responded positively to the Fed’s July hike7. This is a boon for local-currency bonds that have seen their returns negatively impacted by the strengthening greenback.
While the Fed will likely keep raising rates this year, the peak may be closer than initially envisioned. Immediately after the Fed’s rate hike in July 2022, the market appeared to price in a nearer zenith for interest rates8.
This narrative has been bolstered by US consumer inflation data for July 2022, which showed that price rises had eased beyond consensus expectations, with inflation remaining flat on a month-to-month basis9.
Asia's relatively robust economic growth also points toward a turning of the tide. Second-quarter GDP numbers revealed robust performances in markets such as Malaysia10, Indonesia11, Philippines12, South Korea13, and Taiwan14. And while China’s GDP growth saw a dramatic slowdown15, this was mainly because of its zero-Covid policy – rather than any underlying economic fundamentals.
This contrasts with the US, which recently posted two consecutive quarters of negative GDP growth16. While policymakers are steadfastly avoiding the “R-word”, the simple fact is that the US now officially meets the criteria of one of the most widely used recession gauges.
Further, it’s not just the US that Asia stands in contrast to, but other emerging markets as well – many of which have not experienced resilient economic growth. Quite the opposite, in fact.
Over US$250 billion of distressed debt hangs over many weaker emerging-market credits, which risks triggering a cascade of defaults17. Sri Lanka may have just been the first domino – El Salvador, Ghana, Egypt, Tunisia, and Pakistan could be next.
As we progress into the later stages of 2022, this difference could become starker – and we may see global investors pivot back to stronger Asian credits.
Thus far, we have examined why the outflows from Asian bond markets – specifically local-currency government bonds – could reverse in the near future. Yet, there are signs that it is already happening. In the first 10 days of August 2022, it was reported that global investors bought a net U$1.71 billion of Korean bonds and U$721 million of Indonesian debt18.
Once the other factors discussed above come into play, the question becomes: Will this trickle of inflows turn into a flood?
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