(Bloomberg Opinion) -- Bond traders haven’t been feeling this chipper for a long time.
Emerging-market dollar bonds are in full bloom this year. Investors who bought into Asia’s high-yield debt not only have recuperated from last year’s bruising losses, but gained some, too.
Now an inverted U.S. yield curve is giving some reason for pause. On Friday, the spread between three-month and 10-year Treasuries fell below zero for the first time in more than a decade. This has occurred before each of the past seven recessions in the U.S.; even the one false signal in 1966 resulted in the S&P 500 entering a bear market.
Should emerging markets be worried?
On the one hand, an inverted yield curve is no big deal – or even good news – for developing countries. It’s a strong sign from bond traders to the Federal Reserve that its monetary policy is too tight. Chances are, the Fed will buckle under pressure.
During the last period of inversion, a yearlong stretch starting in June 2006, emerging markets’ high-yield bond spreads hardly moved. For developing nations, the first-order of business is the level, rather than the shape, of the U.S. Treasury yield curve.
On the other hand, it’s worth asking why this yield curve inverted in the first place. Some are pointing fingers at Germany’s latest purchasing-managers data. In March, manufacturing activity there fell to levels last seen in 2012, which pushed down the 10-year Treasury yield, a proxy for corporate profitability. The main culprits behind the bad data are the automobile sector and China, where demand for cars is tumbling.
It’s also worth asking why junk dollar bonds in Asia have rallied so fast this year. Sure, the Fed has stepped back from rate hikes, but generosity from China, the elephant among emerging markets, has been another major catalyst. At the start of 2019, the central bank cut lenders’ reserve ratios right after purchasing-managers data signaled contraction. Traders now bet that Beijing is opening its liquidity taps again, and that the economy will recover as a result.
But are bond traders being too simplistic? While high-yield developers in China have raised more than $18 billion offshore this year, they still can’t refinance easily onshore. This is because China’s credit multipliers are broken: Even if politicians all of a sudden talk up supporting private enterprises, banks are simply not willing to lend in an economic downturn.
This raises the question of where China is in its credit cycle, and whether monetary easing can lead to a quick rebound. At this point in the year, it’s almost useless to dissect China’s macro data: the Lunar New Year, which came early in 2019, is messing with readings of economic activity again.
Even China’s stock investors, whose fervor drove the A-share market’s spectacular boom – and subsequent bust – in 2015, are taking a step back as they await April data. Mainland stocks have been trading sideways this month; yet overseas bond traders keep pushing dollar notes higher. I don’t know about you, but I’d go with the locals.
I’m not saying that one day of yield-curve inversion will end this emerging-markets bull run. But if history is any guide, a U.S. recession could ensue in about a year.Last time this happened, emerging-market debt happily churned along for a few months, until one day the music stopped, and credit spreads shot up 2,686 basis points after the Lehman Brothers Holdings Inc. bankruptcy. That party ended in tears.
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Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.
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