US inflation spells danger for Asian currency debt

IFR 2126 26 March to 1 April 2016
6 min read
Jonathan Rogers

How long will the good times continue to roll for Asia’s domestic bond markets? Their resilience in the face of local equity market turbulence has been remarkable, as has been their ability to shake off the first rate increase from the US Federal Reserve in a decade.

The long-awaited capital flight, which was supposed to be a binary function of higher US short-term interest rates, hasn’t gained pace. And the credit stress implied from servicing a raft of dollar debt hasn’t made much impression on corporate yield curves across Asia’s domestic credit markets, even as the greenback powered ahead. China’s debt mountain stares out bleakly, but the “Beijing put” remains firmly in place.

Indeed, outstanding Asian currency bonds grew by around 18% year-on-year in the last quarter of 2015, according to data from the Asian Development Bank, largely thanks to the printing presses continuing to roll at warp speed in China, which accounts for nearly 70% of the regional total.

There was no buyer’s strike, and net foreign capital inflows were even seen in Indonesia, Malaysia and Thailand over the final quarter of last year.

Perhaps this is not so surprising given the sustained decline of those countries’ currencies last year. And there was a benign rate dynamic that pushed the long end of most Asian government bond yield curves lower in the face of declining economic growth. All told, the alpha seekers of Western real money made the right call.

WHAT MIGHT REVERSE this? I’m reminded of a research note put out more than a year ago by Ashmore, the big hedge fund that invests money for, among others, central banks. In the note the rather canny Jan Dehn, the fund’s head of research, made a call that first seemed to be an aside but that might have contained all we need to know: that US inflation would pick up this year.

I quote the report: “We think the Fed will … [allow] inflation to rise, but at the same time [raise] nominal policy rates very slowly. We think inflation will naturally resurface around the middle of 2016 when (a) household deleveraging is over; (b) unemployment is materially lower than today; and (c) the drag from negative equity eases for home owners.”

Judging by US price pressures in the early part of 2016, this seems to me likely to have been a prescient call. US Treasury prices indicate growing expectations that inflation is set to rise in America. The spread between the one-year fixed-coupon Treasury yield versus the like-tenor Treasury Inflation Protected Securities recently rose to a two-year high, while forward swap rates have also been pushing up.

Of course, the recent surge in oil prices off 13-year lows has stoked these expectations, but it’s worth noting the surprise push in US inflation in January, when core PCE consumer price inflation rose to 1.7%, just shy of the Fed’s official PCE target of 2%.

That on its own is good news. Nothing would help the US dollar debt pile, the result of years of zero interest rates and quantitative easing, better than a good dose of inflation-induced debt deflation – and I suspect the Fed will increase interest rates this year faster and by more than many commentators envisage.

BUT WHERE WOULD that leave Asia’s domestic bond markets? Well, in my opinion, in a very vulnerable state. Rising inflation expectations will finally pummel duration on the US Treasury curve and the long end will sell off. Forward swap rates are telling you that already.

Meanwhile, in the face of moribund economic growth, most Asian countries can ill-afford to remain in lock-step with US short-term rates. Indeed, as Japan seems likely to move further into negative interest rate territory and the threat of deflation looms over Asia, you would have to imagine that the region’s currencies face the threat of sustained depreciation as its central banks are forced to accept a widening differential with US interest rates as an incontrovertible fact.

That seems to me the script, and if I were an alpha seeker who had booked Asian domestic bonds both for yield and the currency kicker, I would now be reversing those positions. And I’d be sitting on dollar cash, waiting to pick my moment to enter the US bond market with some steepener trades put on in the swaptions market.

This might be the great moment of triumph for the developed markets over the emerging markets, at least as far as dollar debt versus local currency debt is concerned. I won’t even reprise the call I made in this column weeks ago that the Chinese renminbi will be devalued by as much as 15%, but that possibility remains the bogeyman that could push the boundaries of my call to the maximum.

But if US inflation is indeed on the return and if Asian currencies do shudder, then that inflation will of course be exported to the East. Later on, after the Asian currency adjustment has occurred, rates in the region will need to rise to counter imported US inflation. All told, it seems to me that the death knell for Asia’s domestic bond markets has now been sounded way across the pond.

Jonathan Rogers