Global implications of rising US yields
Events in Italy may have highlighted a crowded short position in long-term bonds, with US 10y yields falling by 0.25% to 2.75% during a week of political uncertainty. However, US bond market investors still have to contend with rising short-term interest rates and a substantial increase in the issuance of US Treasuries to finance Trump’s tax reform. Furthermore, this is happening at the same time as the US Fed attempts to reduce the size of its balance sheet. Current 10y yields appear too low in the context of a continued economic expansion and emerging market policymakers are becoming concerned.
A recent op-ed in the Financial Times by the governor of the Reserve Bank of India, Urjit Patel, suggests that the recent turmoil in dollar funding in emerging markets has arisen not because of rising interest rates but because of the combination of increased issuance of US Treasuries to finance Trump’s tax cuts and the simultaneous reduction in the Fed’s balance sheet. Patel is not alone among emerging market policymakers in becoming concerned; Indonesia’s recently appointed central bank governor Perry Warjiyo has also expressed similar views recently.
Patel states bluntly his opinion, coming from the head of one of the world’s leading emerging market central banks, that unless the US Fed responds to this increased US Treasury issuance by adjusting its plans to shrink its balance sheet, a crisis in emerging market dollar funding markets is inevitable. He also highlights the recent reversal of capital flows, with foreign capital now fleeing emerging markets at the rate of US$5bn per week. In his view, the Fed should change course on its balance sheet reduction program which was in any case designed before Trump’s tax cuts became a reality.
Unsurprisingly, his figures are correct. There has been a substantial upward revision to expected US Treasury issuance over the last 12 months as a result of US tax reform, Exhibit 1. Compared to expectations a year ago, an additional US$260bn of US Treasuries will have to be absorbed by private markets in 2018 and US$430bn in 2019. The US fiscal deficit is now forecast to remain close to 4% of US GDP from now until 2022, rather than 2.5% over this period only a year ago. The additional funding requirements are therefore substantial and will place upward pressure on long-term US interest rates.
Exhibit 1: Significant upward revision to US funding requirements in 2018
In some respects, this easing of US fiscal policy is exactly what the US Fed hoped for – only much earlier in the cycle. Earlier this decade, there was ample slack in the economy and below target inflation which would have created the conditions for policy rates to remain low even as borrowing expanded. However at this juncture, the Fed’s room for manoeuvre is more limited with unemployment at 3.8%, below its long-run estimate of 4.3-4.7% and inflation already close to target.
There is also a significant amount Fed credibility invested in its current policy of gradually normalising US monetary policy, both in respect of interest rates and the size of the Fed’s balance sheet. In terms of the Fed’s balance sheet, Fed Chair Powell stated in November that the balance sheet would decline by US$1.5-US$2trn over the next 3-4 years, and at a rate of US$50bn per month by late 2018. This compares to a peak level of quantitative easing of US$85bn per month earlier this decade. However, following the implementation of December’s US tax reform, this quantitative tightening will occur during same period that the US will be running a 4% fiscal deficit.
In terms of figures, while there is necessarily significant uncertainty, academic estimates suggest that each incremental 1% increase in the US fiscal deficit corresponds to a 0.25% increase in US bond yields. Following the 2% increase in the forecast fiscal deficit over the last 12 months, this indicates upward pressure in the region of 0.5%. The impact of the Fed’s quantitative tightening is also difficult to estimate with precision, not least because it is unprecedented. Term premium estimates published by the Federal Reserve bank of New York indicate that 10y yields may have fallen by as much as 100bps due to the impact of quantitative tightening, Exhibit 2.
Exhibit 2: Term premium compression due to QE may be reversed with quantitative tightening. Source: Federal Reserve Bank of NY
Therefore, we would be inclined to put the impact of a deliberately gradual US quantitative tightening at not more than 0.5% over the next 18 months. Finally, there is the steady recovery of inflation expectations close to 2% and rising estimates of the neutral rate of interest, which Fed policymakers currently estimate at 0.8% (real). Adding these factors together suggests US bond yields should be moving closer to 4%, rather than 2.9% currently.
In respect of Patel’s view that the Fed should change course on its balance sheet reduction, this would be a significant shift in the Fed’s position, given its often-repeated intention to reduce the balance sheet “gradually and predictably”. In addition has also been stated that the primary Fed tool for responding to changes in the outlook is interest rate policy.
Fed policymakers will be aware of research which suggests a linkage between the flow of US dollar credit and US monetary policy. This link is not as straightforward as it may appear at first sight. When US policy rates are rising during an expansion, growth in credit provided to emerging markets is positively correlated with rising US rates, as banks search for yield. It is only when the stance of monetary policy shifts – from accommodative to restrictive – that the risk of a flight to safety out of emerging markets markedly increases. At the present time, the US Fed views interest rates as being in a process of normalisation and that they remain accommodative; therefore at least some data do not support the view that an emerging market crisis is imminent even if it may remain a risk for a later date.
Despite the concerns from emerging market policymakers, while the US Fed may not be on a pre-set course in respect of reducing its balance sheet, in our view to change course would require a meaningful international dislocation, justifying a switch in focus to international financial conditions rather than US domestic factors. In any case, we believe the Fed considers the primary tool for managing near-term shifts in the outlook is interest rate policy. In respect of current conditions, the spread between 2y and 10y rates is already uncomfortably narrow and any widening through higher long-term rates may even be welcomed in the short-term.
Bank of International Settlements (BIS) data suggest that there is US$10trn of offshore US-dollar denominated debt with approximately 30% of this allocated to emerging markets. BIS estimates also highlight derivative transactions which imply a similar additional amount of synthetic dollar liabilities. The link between US policy rates and the potentially volatile behaviour of US financial institutions in allocating credit offshore at various points of the cycle is therefore important. For dollar-reliant emerging markets, the economic risks associated with using short-term interest rates to deter capital outflows also has many unfortunate precedents. However, at least now the nature of these problems are well understood.
The gentle shots across the bows of the Fed’s balance sheet reduction policy, even in the context of a strong US economy, highlight that political and economic risk may brewing in respect of global financial conditions. Should US economic growth remain strong, US rates are likely to continue to rise and a switch to risk-averse financial institution behaviour if Fed policy ultimately becomes restrictive could again lead to a repatriation of capital out of emerging markets. While current interest rates are still some way from that point, it may be a real factor in 2019. Recent market volatility suggests emerging market investors are starting to price this in.
