Sat | Jan 20, 2018

Walter Molano | Fixed income will be tested

Published:Friday | February 3, 2017 | 12:00 AM

After a rally that lasted more than 34 years, the bull market in fixed income may be coming to an end.

Rates peaked in January 1982, when the yield on 10-year treasuries reached 14.59 per cent, and bottomed in June 2016 when they touched 1.71 per cent. All indications point for them to move higher in 2017.

The level of United States economic activity was 3.2 per cent y/y in the third quarter of 2016. The unemployment rate remains well below five per cent. Payroll numbers continue to surprise on the upside, and wages are trending up.

Demographic changes in the US are definitely helping. Approximately 10,000 Americans are reaching their retirement age of 65 each day. This is occurring as the post-war baby boom moves on to greener pastures. This trend will continue for the next 19 years, delivering a massive demographic blow to the US labour market.

The massive fiscal stimulus programme promised by the new Trump administration, along with the reshoring of industries and the continued forced deportation of millions of illegal aliens will put additional strains on labour conditions. This is the reason the Federal Reserve is planning on raising rates at least three times in 2017. There could be more than four rate increases, and it will have an adverse effect on the various bond markets.

Emerging markets fixed income is a relatively young asset class. It was born out of the Brady Bond programmes of the early 1990s, when banks converted their defaulted sovereign loans into fixed income securities.

The idea of the US Treasury was to move these risky instruments off the balance sheets of money-centre banks and on to retail investors, which could absorb the volatility without creating systemic problems for the rest of the economy. The introduction of the new high-yield instruments was well received, particularly since Treasury yields were falling dramatically during the latter part of the 1980s.

Currency crisis

However, the fledgling asset class suffered its first hiccup in February 1994, when the Federal Reserve unexpectedly began raising interest rates. In the space of 10 months, the US monetary authorities pushed Fed Funds up by 250 basis points - draining money out of the emerging markets.

Mexico, which was running a large current account deficit and was in the midst of a difficult presidential campaign, endured a major currency crisis that resulted in a maxi-devaluation. The Fed's draconian monetary policies continued through 1996, draining capital from the asset class and eventually manifesting itself in the East Asian financial crisis of 1997.

Although the Fed eased rates a little in 1998, the die for the asset class was cast. In 1998 and 1999, Russia and Brazil, respectively, were forced into maxi-devaluations when they could no longer support their large current account deficits and currency pegs.

The trend climaxed at the end of 2001, as the Fed continued to tighten, and Argentina was forced off its Convertibility Plan and abrogate on its external debt obligations. Less than a year later, the terrorist attacks on 9/11 pushed the Fed in the opposite direction. Short-term rates were brought down to 1 per cent and a new love affair was rekindled with the fixed income markets.

Slowly, the Fed began raising rates and stopped when they reached 5.25 per cent in June 2006. While there was some stress on the emerging markets, the main problem was registered in the US mortgage market, which erupted into a financial crisis that brought most of the developed world to its knees.

The Fed and European Central Bank's rapid response saved us from the onset of another Great Depression, but it also redirected capital back into the emerging world.

Now, it seems like we may be at the start of another monetary chapter.

There is a great deal of consensus on what will happen next, but there is no unanimity.

A few analysts believe that we may return to the lows on Treasury yields. The ongoing problems with Brexit, further dismantling of the European Union, a crisis of confidence in the US and a host of other problems are in the air.

Moreover, the Chinese currency looks like it is hanging on by a thread. The People's Bank of China has been forced to deplete its reserves in defending the yuan, and it has been limiting access to hard currency.

The escalation of any of these problems could easily explode into a situation where the Fed could be forced to reverse its monetary tightening.

If none of these come to pass, we should see interest rates move higher.

It is important to note that increases in yields have a self-reinforcing feedback loop that pushes yields even higher. In other words, yields do not increase linearly with spreads; they go up slightly more because implicit in higher yields is an increase in financing costs and obligations, and this impacts the creditworthiness of the issuer.

The confluence of these factors could complicate the general environment for emerging markets in 2017.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.