Asia Pacific Head of Fixed Income, Head of SSGA Singapore
Inflation continues to ripple through the US economy, with Fed Chair Jerome Powell admitting that supply chain constraints have actually worsened. Indeed, Treasury Secretary Janet Yellen expects price rises to persist until the middle of 20221.
Bond markets seem to agree. The yield spread between Treasury inflation-protected securities and regular Treasuries of similar maturities – a measure of the market’s expectations for inflation – recently touched multi-year highs2. The Fed is now expected to begin tapering its bond purchases by the end of the year3.
That said, Powell has maintained his dovish stance, saying it is too soon to start hiking rates. Yet, bond market data appears to suggest that an overly hawkish Fed could jeopardise the fragile economic recovery.
A Flattening Yield Curve Could be a Signal of an Overly Hawkish Fed
A flattening yield curve – when the yield spread between short- and long-dated Treasuries starts to narrow – is thought to indicate concerns about the macroeconomic outlook. Since June, it has started to flatten at an accelerated pace. The spread between 5-year and 30-year Treasuries, which was as high as 1.67% this year4, stood at a mere 0.86% as of 22 October5.
This signals that markets are worried that the Fed will be forced to hike rates much sooner than expected to combat sustained inflation.
Asian bond investors should consider this: How would the prospect of accelerated rate hikes and an all-but-certain tapering affect Asian bond markets? To better answer this question, it’s worth examining the Asian monetary-policy landscape and associated economic fundamentals.
A Mixed Monetary-Policy Landscape
The economic recovery in Asia has been uneven, which has been mirrored by changes in monetary policy. The Bank of Korea hiked interest rates in August – the first major Asian central bank to do so since the pandemic6– although it elected to keep rates on hold at its October meeting7. And in a surprise move, the Monetary Authority of Singapore decided to tighten policy by raising the slope of its policy band, the Nominal Effective Exchange Rate, in October8.
In both cases, policymakers pointed toward inflationary concerns as the primary drivers of such tightening. However, South Korea and Singapore remain outliers. Most Asian markets are maintaining their policy rates at all-time lows as they wait for their economies to gather momentum. Meanwhile, China looks to be moving in the opposite direction – seeking to carefully ease its monetary policy, albeit with an eye on inflation9.
Given rates have been rock bottom for so long, the only way for most markets seems to be up. Except, that is, China, where any tightening seems unlikely. This puts most of Asia on track to eventually follow the Fed’s footsteps in tightening policy – especially as vaccination rates accelerate and pandemic restrictions start to relax.
However, what eventually entails can vary substantially. The timing of such tightening remains highly uncertain, and it is possible for accommodative monetary policy to be the status quo well into 2022.
Robust Economic Fundamentals
The good news is that tighter monetary policy is likely to happen in lockstep with a quickening economic recovery. While most regional markets are expected to remain below pre-pandemic levels into 202210, their core economic fundamentals remain solid – especially when compared to 2013’s “taper tantrum”.
For instance, current-account balances and foreign reserves have all increased compared to 2013, with the latter being boosted by the International Monetary Fund’s $650 billion Special Drawing Rights programme11. Central banks have also learned their lessons from 2013, building robust war chests to cushion any potential impact from a Fed taper12. Many of their currencies are also undervalued in real terms, which helps further mitigate any “taper tantrum” effect13. The pandemic has also caused imports to fall, helping improve current account balances – particularly as exports to the US remain strong14.
That’s not to say Asian economies aren’t facing any challenges. A resurgence in COVID-19 cases could spark renewed restrictions and constrain economic growth. Increased government spending during the pandemic has sent fiscal deficits higher. Inflation – while more benign than the US – is a concern, too, especially as commodity prices trend upwards.
Everything considered, Asian economic fundamentals remain steady. For the most part, the region is also in a much better position to handle Fed tapering – even including rate hikes – this time around. With global investors starved of yield, Asian bonds remain a valuable portfolio addition.
Higher Yields Could be an Attractive Entry Opportunity
Most Asian sovereign bonds have seen yields move higher throughout the year – China and Vietnam are notable exceptions. While the increase has been lower than the jump in US Treasury yields, the yield spread is still attractive. For instance, as of 25 October, Chinese sovereign bonds provided a yield pickup of 1.36% over 10-year US Treasuries, while the Philippines and Indonesia offered a much higher 3.34% and 4.42%, respectively15,16.
In addition, if the flattening yield curve proves prophetic and the US economic recovery is poised to stall, diversification is even more essential. Asian sovereign bonds can offer said diversification without the additional portfolio risk that might arise from corporate bonds. And as icing on the cake, the upward yield trajectory most Asian sovereign bonds have seen could represent attractive entry opportunities for investors.
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Diversification does not ensure a profit or guarantee against loss.
International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.
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The views expressed in this article are the views of Kheng-Siang Ng through the period ended 31 October 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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