USD and EM Flows, Bond Liquidation, VIX Correlation

The USD has remained in demand with high yielding currencies feeling most of the pressure yesterday. Judging the durability of this move we may have to differentiate between a portfolio and a macro effect. The portfolio effect is driven by the evolution of nominal financial return differentials. In short, rising US bond yields now trading within its 10-year sector back to levels last seen in January has reduced the relative attractiveness of higher yielding EM holdings. Our EM flow indicator show that there have been at least $2 billion in outflows from EM bonds and equities over the past week, with 85% of that in the 2 days following the election.

Liquidation pressures: Within the post-Lehman word seeing central banks doing most of the heavy lifting to support growth in struggling economies, investors have increased the effective duration within the US bond market from 6 towards near 8 years. Long duration bond portfolios now face capital risk as bond yields rise and bond prices fall. This liquidation pressure meets a secondary market with banks now holding less inventory due to tightened regulation, suggesting that there is less of a buffer function, explaining why bond yields have increased abruptly. There are worries we may see a repeat of the 2013 market when the taper tantrum pushed US 10-year government bond yields from 1.6% to 3%. Hence it seems understandable that investors are shifting portfolios from EM high yield into US equity markets. Investors speculating about the elected President’s ‘putting America first’ and its implications on global trade additionally justify this portfolio shift. A side effect of this outcome is another inverse correlation break.

The US VIX breaks lower while EM high yield weakens. This is new. Other correlation breaks seen since September include the USD now moving in line with industrial commodity prices, US inflation expectations no longer trading down as the USD rises, the US core PCE no longer reacting to falling import prices from China and a rising USD no longer flattening the US yield curve. Trading similarities have emerged with the year 1999 when output gaps diverged in a similar fashion compared to nowadays. Some DM areas including the US seem to be closing their output gaps while other regions in the world are widening. Hence any cost increase registered globally has a bigger impact on those economies where the output gap has apparently closed. This is why the USD has strengthened. Abating global headwinds. Note the global Manufacturing PMI has sharply improved over recent months, and is now at 52. Today, China released its October electricity consumption rising 4.8% Ytd YoY accelerating from 4.5% reported in September and Malaysia’s Q3 GDP came in at a faster 4.3% (consensus estimate: 4.0%). Hence, the anticipated US policy shift falls into fertile soil. Unlike last year when the Fed prepared for a December rate hike, external headwinds have eased. Due to global output differentials better global data have enhanced the position of the USD as an investment currency. The Dow rose 1.2%, to 18807.88, surpassing its previous closing record of 18636.05hit Aug. 15. The index is up more than 5% this week with pro-cyclicals like bio tech and financials leading the advance.

 Market language. Markets have undergone a fundamental change of trading. Not so long ago it was all about yield enhancement pushing funds into high dividend yielding equities, consistent with the rally seen within high yielding EM. Now it is all about growth with investors pulling out of traditional yield enhancement plays including high yielding EM, shifting into growth stories. This ‘portfolio effect’ may have further to go, but we acknowledge too that US real yields have remained low as the increase of nominal US yields has been mostly driven by rising inflation expectations. Should the new US government concentrate on supporting US nominal GDP growth and not raise trade issues then the EM high yield sell should be limited. The chart below shows that the bearish Latam FX move is not justified when using the 10-year US yield as the guide. Should we trade Latam long? No is the answer. AxJ FX shorts offer better opportunities. To turn bearish on Latam we would need to see the new US government ‘playing the anti-globalisation card’ or US real rates rising from here. Both are not expected near term outcomes.