Here's the multi-trillion dollar elephant in the room: no-one really knows what will happen if and when either the US
delays interest payments defaults or -- in the more likely event -- the government loses its AAA-rating.
At Wednesday's open, US Treasuries barely moved ahead of Thursday's debt ceiling vote. At Tuesday's market close, the yield on 10-year treasuries actually fell 5bp to 2.95 per cent, as markets bet a last-minute debt deal would be struck, while the dollar weakened against most other G10 currencies, though, on Wednesday's open the greenback recouped losses.
The ignorance about the potential market impact of a downgrade/default -- combined with the fact that the global consequences of default are so enormous and that in-of-itself logically increases the chance for an eleventh-hour policy response -- explains to some extent why markets are still relatively relaxed about the debt ceiling impasse.
It's not clear what pockets of credit markets will sell off, how long the rout will last, which holders, if any, of US Treasuries will be forced to sell off their positions and, more generally, its impact on global foreign exchange and credit markets.
But against this uncertain backdrop, the potential impact of either a US debt default or a sovereign ratings downgrade on emerging fixed income markets is unclear, and probably accounts for the reluctance of much of the EM-focused sell-side to firmly engage with these -- uncomfortably -- fat tail risk events.
Here's the potential US impact:
- According to a slew of US fixed income dealers, rates strategists as a well as EM analysts and investors canvassed by FT Tilt, there is no consensus on the extent to which US Treasuries will sell-off.
- If pockets of the US Treasury market shuts down in the event of delayed interest payments, it is logical to assume a disorderly jump in US Treasury rates will kick in, especially since over half of the marketable treasury securities are held abroad.
One bearish view on US Treasuries comes from Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management:
With the end of QE2 the Fed has ceased to be a net purchaser of US government debt. More generally than just for the Fed, there is also a key question of how the accumulated government debt holdings of developed world central banks will be reduced. The market’s assumption seems to be that portfolios will simply erode through a process of natural decay as bonds mature and roll off. However, unless there is a fiscal cutting programme draconian enough to reduce outstanding government indebtedness (virtually impossible in our view) the private sector will need to step up to refinance these maturing bonds.
Putting aside the issue of whether inflation in the US will eventually move sustainably higher, the combination of potential rating agency action and these existing pressures suggest US treasury yields will need to go higher in the course of the rest of the year.
But here are the counter-arguments:
- The familiar push for liquid and perceived low-risk assets in a flight to quality sell-off could cap the pressure on the US benchmark. One US interest rate strategist said safe-haven demand will focus on the short-end of the yield curve and T-bills while interest rates at the long-end could spike.
- In sum, it is not clear to what extent markets would enter the uncharted waters of a bear market for US Treasuries in a risk off environment, according to Koon Chow, strategist at Barclays Capital.
More generally, if the August 2 deadline is not met, it won't necessarily trigger an immediate technical default if the US delays paying social security payments and military pay-checks. For more on this, go here.
To sum up the domestic impact then, the market consensus is that a US downgrade and or delayed interest payments might not trigger a disorderly rout in US Treasuries "as much as you might think" -- in the short-term at least, according to Blaise Antin, head of research at TCW Emerging Market Fixed Income Fund in Los Angeles.
Either event, however, will no doubt kick off a risk off environment. The post-Lehman Brothers rout confirmed the asset class's tendency to under-perform in a global market rout -- given risk perceptions, the instability of the investor base and liquidity concerns.
Conversely, the risk off environment should continue to boost the usual DM safe havens: bunds, gilts, gold, the Swiss franc and the Japanese yen, said Timothy Ash, head of EM research at RBS.
The impact on EM debt
As FT Tilt has reported, one of the biggest drivers of asset class performance in recent months has been the sharp rally in US Treasuries, driven by poor employment and industrial data combined with the flight to quality trade set off by the eurozone crisis. During the second quarter, five year and 10 year US Treasury yields dropped over 60bp and 40bp, respectively.
High grade hard currency sovereign bonds are more correlated with the performance of underlying risk free rates than corporate hard currency bonds -- since both asset classes are dollar-denominated and are seen more as more of a rates market rather than credit market. As a result, in recent months, EM sovereigns outperformed EM corporates in all ratings categories save for BB-rated credits.
Still, the recent rally has made EM sovereign debt particularly vulnerable to US Treasuries widening. EM debt yields will widen with any sell-off in the US benchmark while EM debt spreads over UST should remain relatively stable, Koon at Barclays Capital told FT Tilt.
The JP Morgan EMBI index has basically been locked in a trading range of around 250bp-310bp over the past two years. Ash at RBS, reckons the index could sell off by 50bp-100bp in a post-US default rout.
However, if a US default or downgrade disrupts global money market funds all bets are off and EM credit would be severely impacted given the dysfunction in global financial markets that would ensue. Corporate credits would no doubt under-perform given this risk off environment, especially considering the large volume of external liabilities corporates need to roll over in the coming year, according to Koon.
Poole at HSBC is more bullish on EM credit: “beyond the near-jerk, risk off reaction, EM assets should benefit and investors in the fixed-income asset class are not levered” so a wave of forced ceiling is unlikely, he told FT Tilt.
However, Poole concedes “it is difficult to position for this on a cyclical basis since a US downgrade will prove to be a short-lived event”.
Koon at BarCap reckons dedicated EM debt investors are holding "high-ish" cash balances that should help insulate them, to some extent, from forced selling pressure if a wave of redemptions kicks in during a market rout.
In the medium term, there is still a need to generate an income stream so any sell-off would be contained and thus, quality EM corporate and select sovereign credit spreads would have room to tighten once a search for yield kinds in if and when risk appetite returns, Poole said.
(And of course, Brazil, which is burdened with managing one of the EM world's most popular trades -- long BRL --, has imposed further punitive measures to stem the real's rise and repel the capital flood, underscoring hard landing risks in EM.)
Antin at TCW -- who argues that a US downgrade is a done deal -- agrees with the view that under-levered sovereign and corporate credits will overshoot fair value in any global market rout, proving a "good buying opportunity" for cash-rich investors.
The projected global rout in the event of a US default would also be crucial litmus test to determine if select local currency debt markets, the likes of Mexico and Brazil, are more liquid than their dollar corporate counterparts, in emerging Europe, principally, according to Antin at TCW.
The projected weakness of the dollar will boost the strength of EM currencies in trade-weighted terms (and no doubt test further the tolerance of EM policy-makers for currency strength). Antin tips Asian FX, the currencies of Malaysia, Korea, Indonesia and Singapore, in particular. Ash at RBS tips the Singaporean dollar, Czech koruna, the renminbi and the Chilean peso.
Whatever happens, the medium to long-term impact is obvious: the US debt ceiling debate has underscored the relative creditworthiness of EM versus DM -- which should help to erase the valuation gap -- and will heighten EM central banks’ desire to diversify away from the structurally weak US dollar and Treasuries, Poole at HSBC concluded.
What a US downgrade (or default) would mean - FT Tilt Populi
Rating (ir)relevance and downgrade speculation - FT Alphaville
Asia waits and watches after Moody's move on US rating [Updated] - FT Tilt
Coverage of EM debt - FT Tilt
Nowhere to run but Treasuries in US downgrade scenario - IFR