EM: High yields offer some shelter

During recent periods in which UST yields have risen or when geopolitical risks have threatened to spillover to oil prices or key EM economies directly, the level of real yields have partly helped differentiate performance. However, we point out that this is often a partial offset; hence, investors need to be careful about overstating the ‘shelter’ that high real yields gives particularly to EM currencies.

Figures 1 and 2, highlight key periods for the UST and the oil market, i.e., during the taper scares of H2 2013, the bear-flattening period ahead of the mid-2004 Fed hikes (Figure 1), and two periods – one from Nov 2011 to Feb 2012, the other from June 2012 to Sept 2012 – when Iranian/West tensions were very high (Figure 2).

The latter are important periods for EM because oil prices came under upward pressure and at the same time, the tensions themselves represented a direct threat to regional market economies (Turkey and the Gulf States), which could have spilled over to the wider EM environment because of the significance of their markets. This makes analyzing these periods especially useful in gauging what high real yields can or cannot do for EM asset prices during periods of exogenous risk aversion.

The interesting observations from the four distinct periods  (two in Figure 1 and two in Figure 2) are as follows:

·      The starting real yield level affected nominal bond yield performance, particularly when the shock was from higher US yields (bear flattening such as in H1 2004 or bear steepening during H2 2013).

·      The starting real yield level is less important in differentiating nominal bond yield performance when the shock was geopolitical/oil related.

·      Real yields mattered more in the H2 2013 period while in the early (H1 2004) period, the average levels were significantly higher so that other factors were probably more important in differentiating performance.

·      High yielding EM FX enjoyed some insulation from UST shocks but this insulation was limited when the shock was geopolitical in nature.

The relationships between real yields and performance (nominal yield levels and FX) is not very well behaved, which means that while real yield levels seem to matter depending on the circumstance, one should not assume robust levels of insulation. Clearly it is not enough to offset fundamental problems (e.g., during H2 2013, the level of real yields made only some difference to the high current account deficit countries).