US yield shocks: Unkind to EM FX and rates – SocGen

Research Team at Societe Generale, notes that the US 10-year yield has risen sharply in recent weeks and is up 80bp from the cyclical low and SocGen’s fixed income strategists believe the US 10-year yield could rise to 2.5% by the end of 2017 with upside risk to this forecast.

Key Quotes

“We analyze the impact on EM rates and FX during trough-to-peak move in US 10-year yield that exceeded 50bp (“yield shock”) since 2000. EM 2yr and 5yr swap rates have risen for a majority of cases. Swap curves have tended to steepen although a few did not show a strong tendency in move on either side. Average EM FX performance is close to zero during periods when US rates are rising, but in recent years currencies have become more sensitive to moves in US rates.”

“The pattern since 2013 (weaker EM in the face of higher US yields) is the template that investors should keep in mind. Prolonged low interest rates and unorthodox central bank policies (QE, ZIRP, NIRP) have undoubtedly caused a misallocation of capital and a higher sensitivity of EM currencies to changes in US (and global) rates.”

“In the two most recent yield shocks (2013 and 2015) EM currencies have weakened, which is being repeated in the current episode. The increases in EM swap rates were particularly consistent during the 2013 and 2008 episodes with huge magnitudes of moves as well – biggest move on average during the 2013 shock.”

“There is plenty of room for US yields to rise (40bp) to reach the average trough-to-peak move since 2000. If yields rise to this extent, and especially if investors believe that the secular bull market in US (and G3 fixed income) is starting to reverse, there will be more pain ahead for emerging market investors.”