Emerging Markets: Steepening Treasuries curb appeal – BNY

BNY’s Geoff Yu reports that sovereign bonds from commodity-based EM economies have seen accelerated selling after the Fed decision, despite a weaker Dollar and lower U.S. real yields. South Africa failed to attract inflows even with higher Gold prices, as EM duration remains challenged by insufficient nominal yields, inflation risks and fiscal stress versus comfortable U.S. yield dynamics.

Commodity-linked bonds face duration headwinds

"Sovereign debt issued by commodity-based EM economies normally benefits from USD-funded trades in a dovish Fed environment, but selling accelerated after the Fed decision. There are some early signs of reversal, yet South Africa, which should be one of the clearest beneficiaries of higher gold prices, failed to register a single inflow session until a full week after the decision. This suggests the environment remains difficult for EM duration."

"Front- and back-end nominal yields are simply not high enough to compensate for inflation risk and fiscal stress. Given the current global growth outlook and the unexpected fiscal burden arising from the Iran conflict, we have some sympathy with this view. Central banks can’t impose fiscal discipline in the way bond markets can, and the required price adjustment hasn’t yet been reached for a sustained EM asset recovery."

"Despite high inflation, developed market sovereign bonds found strong domestic support throughout the Iran conflict. Local investors don’t face FX risk, while limited movement in breakevens keeps real yields attractive. This remains broadly true in Europe, but the Fed decision was a game-changer for U.S. breakevens: the 5y5y forward measure has risen 20bp over the past month and almost 30bp from its March lows."

"Even so, the decline in U.S. real yields has been insufficient to generate strong flows into commodity-linked bonds because Treasury curve steepening has offset much of the benefit. The weaker-dollar view is intact, but that doesn’t automatically translate into stronger commodity prices or stronger commodity-linked economies, particularly while U.S. investors remain comfortable with domestic nominal and real yields."

"Commodity economies therefore need to generate their own growth and total-return narrative before they can fully benefit from easier global financial conditions. The earlier combination of a wide yield advantage over the U.S. and strong Chinese demand boosting export revenues isn’t returning."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor. Know more.)