What Does A Flattening US Treasuries Yield Curve Mean For Emerging Markets Bonds Investors? 3

Stimulus measures in the developed world, particularly in the US, Europe, and Japan, have been undoubtedly beneficial to emerging markets bonds and equities. As yields in the developed world remained depressed, investors ventured into riskier, but much higher yielding asset classes.

However, capital flows have been drying up of late, and have even reversed in some cases, as the spreads between emerging markets and the US have declined as shown by the graph below.

Spreads can compress because either yields on emerging markets bonds come down, or because those on US Treasuries have gone up, or a combination of the two.

- Advertisement -

Looking at US Treasuries

The graph below shows the US Treasuries yield curve on a quarter-end basis starting in December 2015 when the Federal Reserve hiked its short-term federal funds rate for the first time in 9.5 years.

As far as short-term tenors (SHY) are concerned, the rates on June 30, 2017 are higher than any other period on the graph. However, there are interesting data points to note on the medium (IEF) and long-term (TLT) tenors.

Compared to the first three quarters of 2016, the yield levels at the end of June 2017 are higher across the curve. Comparatively, from December 2016 to March 2017, there is no difference in yield on the 5-year note whereas yields on higher tenors were lower in June than they were in earlier quarters.

In fact, yields on 20 and 30 year bonds were lower in June as compared to December 2015.

This indicates that the US Treasuries yield curve has been flattening. While short-term rates respond to rate changes by the central bank, long-term rates are influenced by expectations on inflation. Higher inflation expectations lead to higher rates. But if short-term rates climb faster than long-term ones, they lead to flatter yield curve compared to a traditional upward sloping curve.

What does this mean?

The above indicates that the compression of spreads has been a result of both components: US Treasury yields rising and emerging market bond yields declining.

But given the fact that the US Treasuries yield curve is flattening, this will have important implications for emerging markets bonds investors. In the next article, let’s see how this and other aspects may shape portfolios invested in the asset class going forward.

- Advertisement -