Treasuries: Real Yields Flash a Warning Sign
Recent Treasury weakness could spell caution for emerging markets.
This post is two-faceted as I will be looking at two different recent developments. The first highlights the causa proxima behind the most recent sell-off in Treasuries. The second is broader -- I take a look at recent highly correlated changes in different asset classes that smell very funny when considered together.
The sell-off in the past five days in Treasuries has been led by the 7-year note, which implies that it was futures-driven, and a byproduct of the contract roll. One thing to keep in mind is that the 10-year futures contract (symbol: TYU4 or /ZN) in fact trades to a 7-year Treasury note. The cheapest-to-deliver note for the September 10-year future is currently the 3.125% 10-year of May 2021 (time to maturity: seven years).
Additionally, the 7-year was the worst performer on the curve in the past five days and has underperformed vs. the 5-year, 10-year, and 30-year on a butterfly or curve basis. Not surprisingly, it saw relative outperformance on the way up. The changes are from May 29 closing prices:
- 5/7 curve: 5.12bps steeper
- 7/10 curve: -3.1bps flatter
- 7/30 curve: 5.49bps flatter
- 5/7/30 butterfly: +11.16bps
- 5/7/10 butterfly: +8.5bps
(Remember that Treasury butterflies sell two of the center vs buying one of the wings, different than an equity options fly.)
It was very peculiar to me during the sell-off why the 30-year wasn't leading; it is the most expensive part of the curve right now in my opinion. But after looking at the above information, it makes sense now. Conversely, this explains why the bond rally in the days leading up to May 29 (when the roll was at its heaviest) was driven by a lack of real sellers in futures. (Hat tip to Vince Foster for floating the idea.)
The second thing I'd like to point out is how real yields have been leading the latest sell-off in Treasuries. At the same time, the dollar has been rallying against sell-offs in a number of vulnerable emerging market currencies. Counterintuitive to basic economic theory, if the dollar is rallying, therefore making said country's exports less competitive and its total growth lower, this would lower its yields. In the case of a carry trade, it works out to the inverse.
A quick history lesson on why USDJPY was the carry trade du jour pre-crisis. The Bank of Japan has kept rates at effectively zero since 1999, meaning that it was advantageous to fund in yen to buy US assets. The same is true for using the USD as a funding currency for EM trades. The max policy rate for the USD is probably 3% or lower, currently at 0, vs 11% in Brazilian real, for example. Countries that are more mature in growth have lower policy rates as a result, making them the ideal funding currency.
Since the May 29 peak, the 5-year inflation breakeven rate has widened by 4.6bps and the 10-year by 6.6bps -- meaning that real yields have been underperforming nominal Treasuries by those amounts during the sell-off. And to add the proper color/caveat, both have been coming off their highest levels in the past 13 months. At the same time, a number of EM countries, including those with the weakest current account balances, have been under noticeable pressure. Those include the Turkish lira (TRY), Russian ruble (RUB), Brazil real (BRL), Mexican peso (MXN), Indonesian rupiah (IDR), and Indian rupee (INR). This is strikingly similar to the Treasury sell-off we experienced back in May 2013, when the dollar and real yields led higher.
This could also mean that emerging market bonds/stocks will come under additional pressure, too. And we've already seen it in emerging market bonds. The local 10-year Brazil sovereign bond is 22bps wider to US Treasuries in line with the latest currency move (it has a 10% coupon).
Other than pointing out the "what" I don't have any other legitimate opinions that I can add. This is not something to panic about yet, but something I am watching closely. As Jeff Cooper suggested earlier today on the Buzz & Banter [subscription required], with this kind of behavior, this is not your garden-variety pullback.
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