Fixed Income

EMD Relative weekly notes

Week Ending June 3, 2016


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Today's US jobs number is likely to be a significant positive catalyst for emerging markets (EM), EM debt, and EM currencies.

We had recently expressed caution on two of our three key investment themes for the asset class, as Chinese yuan (CNY) stability was threatened by a steady but quiet depreciation and major central bank support began wobbling with hawkish Fed talk, though oil prices and fundamentals remained steady. All three will now be flashing green for investors absent new macro developments. It’s notable that even before today, the weekly mutual fund flow numbers remained positive--an indicator for us that the global search for yield was raising the bar for investors to flee the asset class. Today's developments should add fuel to those flows.

Following the weak job numbers the market’s implied probability for a June rate hike fell from 20% to 4%, and from 52% to 20% for a July hike. The Fed would have a massive task ahead of itself to get the market onside for even a July hike given that pricing--possible, but difficult.

The US dollar—a key driver for EM--fell in tandem as two-year yields took their largest tumble in nine months. In May, the dollar index had climbed 3.5% and returns on the local currency index fell 5.44%--a typically correlated result. Unless the market markedly shifts its current stance on the Fed and that puts a boost into the dollar, local currency assets now have a much better macro environment in the coming months, and EM currencies jumped this morning by about 2% on average in response to the US data.

The Chinese Yuan (CNY) follows from the dollar. Though the Chinese insist their currency is managed against a basket, its performance, just like the broader EM universe, has become a mirror image of the dollar. This morning the CNY was at 6.58 prior to the jobs number and is now at 6.55, about a 50 basis point appreciation. So it’s fair to conclude that the weaker dollar reduces China tail risk fears, which already seemed to be muted.

So what could go wrong with what seems like a sunny scenario? Perhaps an overall risk-off sentiment, and indeed US equities fell as the economic growth perception shifted to a more negative outlook. However, the fall was not very sharp and the VIX volatility index is up a mere 0.24% as of this writing. So for now we are managing our EM exposures to reflect a much more robust environment for EMD, particularly for local currency.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.